Why Net Annualized Return can be Deceiving
Lending Club uses a metric they call Net Annualized Returns to track the performance of your lending portfolio. On the whole NAR is not a bad metric. Evaluating the performance of portfolios of loans is challenging. NAR is designed to be a representation of the actual return to date of your portfolio and it is a good approximation of that. However, if you are interpreting your NAR to be an indicator of your expected return you will likely be dissapointed because NAR drops over time.
3 Reasons why NAR drops over time
1. Service Fees
Lending club has a 1% servicing fee that is charged as borrowers make payments. When a loan is young the portion of a payment that is interest is high but by the last payment the proportion that is interest is almost nothing. The 1% fee is exactly 1% of the payment, it is the same amount for the first payment as the last payment. Therefore the ratio of interest to service fee changes over the life of the loan.
Below is a graph created by calculating the NAR of a portfolio of 10% interest rate loans that never default. As you can see by the end of the loan term the NAR has dropped by about .3% soley because of the fee to interest ratio.
2. NAR does not discount your principal for late loans.
When one of your notes becomes late it is much more likely to default than a current loan. NAR takes this into account by not adding the late payment for that loan into your return, but it does not take into account the very high likelihood that you will lose all the princiapl invested in that note. NAR only subtracts the principal once the loan is officially in default. Recovery rate for late loans are reported at the bottom of the page here. You can see that 31-120 day late loans are only recovered 53% of the time. Since loans can be late for 4 months before they count as a default your NAR gradually drops as late notes default. When calculating NAR on this site we always adjust the calculation by assuming you have lost a proportion of the principal of a late loan according to those recovery statistics. We call this adjusted net annualized return or ANAR.
3. Less Loans Default in the First Month
It turns out notes are actually significantly less likely to default in the first period or two.
So after just one payment period NAR is usually nearly equivalent to the stated interest rate of the note. Default rates rise to their standard level by the 3rd payment but since NAR averages the return over all periods it takes longer for the influence of that first near perfect period to diminish, causing NAR to decline gradually.
4. NAR declines more slowly (or not at all) because of new loans.
Your portfolios NAR likely didn't decline quite as steeply as the picture above. This is becuase you probably reinvested your payments in new loans. Those new loans are subject to reason 3 above and have high NAR at the beginning. This slow influx of new loans slows the decline of your NAR or even raises it if you buy enough.
In the case of the NAR for all investors reported by Lending Club this new loan effect is even more pronounced. You can see from the graph of Total Loans Funded that they have been selling exponentially more loans as time goes on. This means a greater portion of all notes are young and are subject to overestimated returns.
So how should we measure peer lending returns?
If NAR isn't the best way to measure your portfolios performance what is? If you want to measure the return on your own portfolio and most of the notes are over a year old then NAR is at least a reasonable indicator of your returns. To be a little more accurate you should calculate the internal rate of return for your account and you should discount notes that are in late status.
It is still possible to get great returns with peer lending.
Even though peer lending returns are overestimated you can still get great returns, and if you choose your loans right you can even beat the exaggerated returns.