P2P Loan Underwriting - An Investors Perspective
Underwriting and Lending Club
Lending Club has created a great platform for those looking to diversify investments and looking for a new lower risk revenue stream. Lending Club has cut out the middleman (in other words, the bank) and allows individuals to become lenders. As a newly-minted lender or someone who's been on the Lending Club platform for a while you do not have the same tools that a big bank might have. Banks have an army of underwriters and financial analysts that are skilled in assessing risk and credit. Lending Club has done some of that legwork for you, but it is still up to you to assess how much risk you're willing to take. Lending Club loans allow you to look at a number of different data points for you to assess risk. You’re not able to read the credit reports but there are many items on a Lending Club investment that you can use to get an idea of the risk on the loan. We are going to review some of the tools and strategies that underwriters look at and apply them to the Lending Club platform. Some of these items aren’t on the Lending Club platform but every underwriter understands and uses the 5 C's of credit: character, capacity, capital, collateral, and conditions.
In what type of person or borrower are you investing? What behavior patterns can you consider to help you assess the risk of the individual? Many associate character with credit history. But you should also consider stability of the borrower with regard to length of residency and employment. Stable borrowers tend to live in one area for long periods of time or have mortgages. This type of borrower is much less likely to default and generally has a higher credit score. Another measurement of stability is time on the job. Someone who is in the same industry or the same job for a long period of time is a better risk than someone who jumps around from job to job and doesn't have consistent income. Lending Club allows you to view whether the borrower is a homeowner and the length of his or her employment. These characteristics can be set as filters in order to find other stable borrowers who might fit your risk profile.
You are not able to see the full credit report on Lending Club, but the credit score range is listed in the investment. Lending Club does have a credit profile and there are many filters on the platform you can use to find a borrower with characteristics you prefer. We will briefly review each item in the Lending Club credit profile and assess the item and what it means for risk.
Credit Score Range
The credit score, or FICO score, is a measurement of credit risk. The higher the score the less likely your borrower will default. Typically borrowers with a credit score over 650 are less likely to default. The FICO score is one of the best tools for assessing risk. The overall score is made up of these percentages: repayment history is 35%, accounts owed is 30%, length of credit history is 15%, new credit is 10% and credit mix is 10%. The Lending Club platform does not normally allow anyone with less than a 600 credit score. That cutoff eliminates a very large pool of potentially poor investments and potential borrowers. The lower the credit score, the higher both the risk and the interest charged to the borrower.
Earliest Credit Line
Earliest credit line lets you know when the borrower first obtained credit. The longer the borrower has had credit without major delinquencies or public records, the higher the likelihood the borrower will pay back the loan. This can also be used with how many lines of credit the borrower has. If they first opened the line of credit a year ago and now have 13 lines of credit, they are clearly a heavy credit user. This may not mean that they will default, but it is a higher risk.
Open Credit Lines/Total Credit Lines
The total amount of credit used and the current open lines of credit give you an idea of the borrower’s credit use and whether they are paying. You would typically want to invest with someone who has had many lines of credit and has paid as agreed.
Revolving Credit Balance /Revolving Line Utilization
Revolving amounts usually refer to credit cards. Looking at the total balance of revolving credit and how high the borrower’s utilization is will give you an idea of what type of credit user they are. A borrower with high utilization in high revolving balances will be seen as a higher credit risk. It is important to note that home equity lines of credit are also included in the total revolving balance and utilization. Equity lines of credit are lower risk loans than credit cards. So if a borrower looks to have a very large revolving credit balance it may be due to an equity line of credit on their home.
Inquiries in the Last 6 Months
Inquiries in the last 6 months will give you an idea if the borrower is seeking out credit. You cannot see specifically what type of inquiries they are, but if a borrower has a high amount of inquiries it could signify they are in financial trouble and seeking credit wherever they can. However, this is not always the case; for example, if the borrower needs an auto loan, a used car dealer will send out their credit report to five different lenders who will each pull credit. Each of these will show up as inquiries. This is just another small piece of forming a whole picture of the borrower’s behavior pattern.
Accounts Now Delinquent
Any borrower who has accounts that are currently delinquent should be considered a high risk. It is not possible to see all delinquencies because being 30 days late on a $200 credit card bill is not the same as being 30 days late on a mortgage. But it can still give you a good idea of what type of borrower you're dealing with.
Delinquent amount will give you an idea of how much the borrower is currently delinquent. You can use this information to make an educated guess as to what type of account they may have. Is it a late credit card payment or a late mortgage payment?
Delinquencies (Last 2 Years)
Delinquency in the past 2 years gives you an idea of how many times the borrower has been late on their payments within the last 2 years. A borrower who is consistently late or delinquent with their credit is a high risk. If you want the higher interest rate and return this may be a risk you're willing to take, but a borrower who is consistently late in making payments is a higher risk than the other borrowers on the Lending Club platform.
Months Since Last Delinquency
This is a great tool. It lets you know how long since the borrower’s last delinquency. If it was 2 months ago, that should be seen as a higher risk. But if it was 36 months ago and there has been no delinquency after with a good payment pattern since, this is a good indication of a stable borrower.
Public Records on File
Public records are normally bankruptcies or tax liens. A borrower with either of these issues will definitely be a higher risk. A borrower with a tax lien is a borrower you may want to avoid. The government can come in and liquidate the borrower's assets to pay the tax lien. This may hurt your chances for repayment of the loan. A bankruptcy should be looked at very carefully. You are not able to access the full credit report. Therefore cannot see the exact date of dismissal or what type of credit has been re-established since the bankruptcy. These loans should be avoided.
Months Since Last Record
Months since last record will give you an idea of when the tax lien or bankruptcy occurred but it really doesn’t make clear the credit history since the bankruptcy or tax lien. These borrowers should be highly scrutinized if you're looking to invest in them.
Collections Excluding Medical
This is a great piece of information on the borrower's credit. Many people have collections on their credit reports due to medical bills, and they don't even know it. There are thousands of small medical practices that don’t have the clout or the ability to call consumers over and over again to get a bill paid. Many medical collection amounts are small, less than $500, and often the borrower has no idea it's on the report. If the collections excluding medical is very large the loan should be avoided because it will be higher risk. Borrowers with medical collections on their credit report will have a lower credit score since any type of collections will lower the score. This is a great opportunity for you as a lender. If the borrower meets all of your other criteria and is currently paying on all their other lines of credit, they are a good risk and someone who pays their bills as agreed. However, their lower credit score means you can charge a higher interest rate.
Capacity is the ability of the borrower to repay the loan; in other words, the ability of the borrower to be able to produce the cash flow needed to cover their obligations. The main measurement of capacity is debt to income, or DTI. DTI is monthly obligations or debts divided by monthly income. Lending Club already puts a cap on their borrowers’ DTI which is 35%. Many lenders will go higher, usually with collateral. This measure is important because it tells you how much of the borrower's income is going to just servicing debt. The higher the debt-to-income ratio the more the borrower’s income is being used to pay debt and the higher the risk of the loan.
Capacity also deals with how the borrower will handle the new debt. Where does the borrower get income and what does the company consider as income? An underwriter would be able to verify income through taxes, pay stubs, pension statements, etc. Lending Club does not disclose how it verifies income or what it considers income. This is one tool that underwriters use to help measure capacity. There are certain sources of income that some institutions will not consider as income. If Lending Club is lenient with what they consider as income, more so than other institutions, it would increase the level of risk to you. Perhaps they are more conservative. Since we do not know the sources that Lending Club uses, we have to assume they are lenient. Lending Club has a filter that allows you to look at loans that have verified income according to Lending Club. Anyone can state any amount of income on an application so using verified income gives you a better idea of how much capacity this borrower has to cover their debts. Underwriters usually like to see a history of consistent and ongoing income.
The Lending Club platform confirms employment and verifies income. You can use this to help you measure capacity. Remember that high income doesn't necessarily mean they will be able to pay their debts. There are many high-income earners who drown themselves in debt. Using DTI, employment length, and verified employment will help you understand the capacity of the borrower to pay back the debt.
Capital helps underwriters understand how a borrower can meet their short-term and long-term financial obligations even in serious financial hardships. Unfortunately, Lending Club does not look at liquid assets of borrowers. They also don't have anything on the platform that can indicate the borrowers’ liquid assets. Other institutions that do large unsecured loans like to see strong net worth as a secondary source of repayment of the loan. Capital includes liquid and tangible assets. Liquid assets are stocks, bonds, or similar entities that can be easily converted to cash. Tangible items are homes, cars, and other physical assets. Lending Club does not have any information on liquid assets but there is one tangible asset we can evaluate, and that is home ownership. You can use the home ownership filter on the Lending Club platform to find borrowers who own homes or have a mortgage. Usually those who own homes have a higher net worth and are a lower risk borrower.
Currently, Lending Club doesn't offer any loans with collateral. Usually loans with collateral are backed by a car, real estate, or some other type of tangible property and have much lower default rates. Collateral is seen as a secondary source of repayment. If Lending Club were to use collateral it would have to be evaluated according to the market value. Since Lending Club doesn't have that option yet, we'll move on to the next C.
Conditions include a wide range of items including regulation, interest rate, lending policies, overall economy, social issues, and loan use or any other relevant influence on the loan. One great thing about the Lending Club platform is that it deals with government regulations so you don’t have to, except for filing your taxes of course. A condition could be, for example, that the expected return on one investment might not be worth it to you. It may meet all the criteria you're looking for but the risk is not worth the payoff. Another condition could be that the borrower meets all of your criteria but the loan purpose is to pay down gambling debts. You may not want to invest in that loan. You may want quicker repayment periods on your loans and so you don't do 60 month term loans on the Lending Club platform. Another condition could be that you don't want to lend any more $15,000 on the platform. An underwriter would take all of those conditions into consideration. If the economy is sour they might be more stringent with their underwriting standards and lend to only the best borrowers.
The Lending Club platform offers investors a lot of information in order to make an informed decision on the risk of their loan. If these tools are used wisely, it’s possible to increase your return and decrease your defaults. Lending Club is a great place to get better returns than a CD or bank would offer but doesn’t require the same risk a stock or bond would. Use the 5 C's of credit that underwriters use to help you reduce your risk and increase your income.
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