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The Difference Between a Default and a Charge-off at Lending Club

by Peter Renton on April 24, 2012

If you have a well diversified p2p lending portfolio then defaults are annoying but they are unlikely to do too much harm. Regardless, we want to minimize them as much as possible.

But what is a default exactly? It has always been a little curious to me that defaults are treated differently at Lending Club and Prosper. At Lending Club a loan moves from late into default before it is charged off whereas at Prosper there is no intermediate category, notes just go from late to charged off.

Why is there this intermediate category at Lending Club? When I asked this question they provided this as an official response:

In general, a note goes into Default status when it is 121 or more days past due.  When a note is in Default status, Charge Off occurs no later than 150 days past due (i.e. No later than 30 days after the Default status is reached) when there is no reasonable expectation of sufficient payment to prevent the charge off.  However, bankruptcies may be charged off earlier based on date of bankruptcy notification.

Of course, this leaves more questions than answers and also leaves out an important piece of information. Defaults and charge-offs affect your account in different ways.

Defaults and Charge-offs Impact Your Account Differently

When a note moves to a status of default it will reduce your Net Annualized Return (NAR) but not your account balance. When a loan moves from default to charged-off the outstanding principal is removed from your account and your balance is adjusted accordingly. This two stage process can indeed take up to 30 days to complete although sometimes, particularly in the case of a bankruptcy, it can all happen on the same day.

If you have a relatively new account your NAR may be impacted dramatically by your first default. In my new Roth IRA account, where I invest in loan grades D-G, my first default sent my NAR down 2.26% whereas in my main taxable account that is nearly three years old a recent default sent my NAR down 0.07%. In both cases my account balance reduced by less than $25. This big difference is because the loss in a new account is so large compared with the total interest gained that is has a large percentage impact.

Of course, you can avoid defaults altogether if you sell loans on the trading platform as soon as they become late. But that is a post for another day.

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{ 22 comments… read them below or add one }

Marc April 24, 2012 at 7:23 am

Peter,

Thanks for covering this. I’m now recovering from my Charge Offs. It was frustrating trying to figure out when the stats Lending Club was reporting would fully reflect the damage done. As far as I’m concerned, as soon as a Note is Late, the money is gone (a shame the LC stats don’t show that for 150 days).

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Danny S April 24, 2012 at 7:28 am

I had an LC note which was in Grace Period go straight to Charged Off when BK was filed by the borrower. So can happen at any stage of the process.

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White Coat Investor April 24, 2012 at 10:47 am

I avoid this problem by calculating my own return. I don’t trust LC and Prosper to do it properly anyway. They can’t even report their past returns accurately. Compare what they report to what you see on Lendstats.

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Peter Renton April 24, 2012 at 3:04 pm

@Marc, Well certainly not all late notes will get charged off but they do make it impossible to sell that note for a profit. Glad to see you are recovering from the charge offs.

@Danny, While it is rare for an IGP note to get charged off I have also seen it happen. But most of the time these bankruptcies happen when the note is considerably late.

@White Coat Investor, I always recommend people calculate their own returns because the numbers at Prosper or Lending Club can easily be 1-3% off or even more. And if you have much trading platform activity then the difference can be much greater than that.

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Bryce M. April 24, 2012 at 6:26 pm

So, then advertising that X% of loans are “in default” is shady in my opinion because that is just a transitory category. To reflect the true share of problem loans, one needs to look among loans that have finished their term and have charged off. But, 1% defaults sounds so much better.

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Peter Renton April 24, 2012 at 10:17 pm

@Bryce, It brings up an interesting question and one that is never addressed in marketing. Neither Lending Club or Prosper talk about charge-offs they only talk about defaults, particularly in reference to an annual default rate. At Prosper we can say this is unambiguous because there is only one status for defaults, but at Lending Club using the term default is misleading – because do they mean defaults, charge-offs, or an addition of the two? When talking about an annual default rate I would expect they mean the latter but it is certainly not clearcut.

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Dan B April 24, 2012 at 11:12 pm

Peter…………I feel like I might be missing something here. Are you (or is anyone else) in any way suggesting that there have been instances where a “defaulted” loan does not later get “charged off”?
Because if you are then that would be interesting & I’d love to see the evidence. If however you’re not suggesting any of the above, then I’m not quite sure why the distinction between the terms isn’t just academic.

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Simon April 25, 2012 at 12:40 am

Hi Peter! I would really value reading something about how to look at loans once they’ve passed the LendStat filters we’ve been using. At what point do you let bad spelling effect your investments? What if they use emotional language? (IE: “I promise I won’t default!!!”) I would love to hear what things you look for when you find a loan that passes your LendStat filters.

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Danny S April 25, 2012 at 7:19 am

Simon… I’ll answer and I’m sure Peter will too.

For me… bad spelling, if its just one word, I can let slide. But if there are numerous spelling errors, or horrible grammar, I do filter those notes out. I have ZERO evidence those notes are riskier. But its an emotional thing for me… if a borrower cant take the time to properly spell check their loan request, I dont want to fund it.

I also filter out “emotional language” notes, especially people who “promise not to default” and then have some sort of late payment or other negative item in their credit history, even if its 60+ months ago. Again, zero evidence that such language makes a borrower riskier… but just the impression I get leaves me less willing to lend to such borrowers. I’d never use such language on a loan app with a bank or credit union, and I dont think its appropriate here either.

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Danny S April 25, 2012 at 7:21 am

Let me also add, I also filter out anyone who has a late payment or other negative item on their CR, but as part of the question/answers, writes they’ve either never been late, or dont know if they have.

If they dont have an excellent grip on their CR, that may make them less likely to care about it. Another “no evidence” filter I use.

On the other hand, if they have a plausible response on what happened, I usually dont filter out that borrower.

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flyp52 April 25, 2012 at 10:45 am

I have had a loan come back to life from the Default state. I have a recollection that I even had a loan that got completely paid off just days after it got charged off – that looked a little suspicious. I should have written down the loan number.

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Neal Smith April 25, 2012 at 11:09 am

@Simon Maybe this is obvious, but if the word “bankruptcy” is used in the description I’ll pass. My very first prosper loss was on a listing where the borrower tried to explain a past chapter 13. A recent prosper listing said “I need thias loan to avoid bankruptcy”.

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Brady April 25, 2012 at 6:44 pm

Here is my understanding:

Financially speaking a loan is defaulted the minute the contract terms aren’t met – so if a borrower misses a payment, they have defaulted on the loan. However, many loans, including these from LC, have provisions in the contract (see Lending Club’s borrower agreement item #6 Fees) where the borrower is first given a window of time to come back into compliance – a grace period, then different stages of lateness with charged penalties.

When this second chance window expires (see Lending Club’s borrower agreement item #7 Default and Termination), the lender formally claims the borrower is in breach of contract and declares an Event of Default. This term triggers the entire loan balance outstanding to be immediately due, no longer offering the payments to be made according to the payment schedule.

After this, if the lender then doesn’t believe there is commercial benefit on performing any more collections activities they begin to declare the loan bad debt and write-off.

https://www.lendingclub.com/info/loan-agreement.action

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Mike April 25, 2012 at 6:49 pm

One spelling or grammatical error is grounds for me to eliminate the loan from my consideration. I also eliminate any loan that uses the words ‘financial freedom’ or ‘help’ in the title, or any language that implies desperation on the part of the borrower. I also eliminate any listing where the borrower keeps adding comments on a daily basis like “thanks for all who have contributed so far”, or “I promise to pay this loan off early”, or any similar type of comment.

Back on topic, Peter, are you suggesting that LC specifically designed these two categories to make their bad loan rate look better than it actually is? Is there a way to determine how many or what percentage of defaulted loans get back to current status?

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Peter Renton April 25, 2012 at 7:23 pm

@Dan, I have not seen a note come back to current status once it has defaulted and as Brady points out, this is not actually possible given the terms at Lending Club. The point of this post was to highlight the differences between the term “default” and “charge off”. But I take your point from LC’s perspective these are probably just semantics and don’t really enter into the equation at all.

@Simon, To be honest I rarely take any action on a loan once it has passed the Lendstats filters I have setup. I probably only read the details of 10% of the loans I invest in – because I want to let the numbers select the loans for me. Could I do better if I added this extra step? Possibly, but I have not seen any evidence of this qualitative type analysis improving returns. But each investor has to do what they are comfortable with and as you can see in the responses from Danny, Neal and Mike there are other ways of looking at this.

@Flyp52, I haven’t seen that happen to me, but when you look at the entire data download there are certainly instances of that happening at Prosper and Lending Club.

@Brady, Thanks for the clarification and the link – that all makes sense.

@Mike, I am not suggesting that LC designed these two categories to make anything look better. And when you look at the data download there are no loans with a status of Default that have a zero balance on remaining principal but there are plenty of Charged Off loans that have since been fully paid. I really don’t think there is anything sinister at work, but there is some ambiguity in the use of these two terms at Lending Club that doesn’t exist at Prosper.

Speaking of Prosper, they actually have a separate category in their data download for Defaulted (PaidinFull) so you can see those loans that were written off but have since been fully paid. At Lending Club they maintain a status of Charged Off even when the loan has been fully paid – to be fair there are only 10 loans in their entire history that have been fully paid after being Charged Off.

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Louis Lamoureux April 25, 2012 at 8:22 pm

Hi Simon,
I just passed on a loan that met my criteria, the loan title was “Help” and the description said, “God Loves Me”.
Red Alert Red Alert

I also pass on keywords like “miracle” “Bankruptcy” anything religious. I don’t have evidence, I just sleep better at night. I also skip anything medical related. Medical expenses are one of the biggest causes for bankruptcy, so if they are consolidating medical bills, or they mention they were out of work because of illness or surgery Skip.
Lou

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Mike April 25, 2012 at 8:28 pm

@ Lou, Since God loves him, I’m sure he’ll fund the loan himself fully. Good point about medical expense loans. I have never invested in those for exactly the same reason you quote.

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hopehickory April 26, 2012 at 10:55 am

I now have 2 out of 163 loans that are in collections. This is shocking to me because both of these borrowers made only 1 payment before starting to default. Neither of these had any blemishes on their record in terms of late payments, past defaults or bankruptcies. The only worry was that one was a B and the other was a D loan. If both of these become charge offs that will drop my APR from 12 to 7% I think. I can only assume more loans will default at time goes by. If the number of defaults increases I am going to have to reconsider investing any more money into this questionable investment vehicle.

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Dan B April 26, 2012 at 2:38 pm

Hopehickory………Unless the 2 loans you refer to are of a much higher dollar value than your other loans, I’m certain that your NAR or ROI will not go down by the 5% you suggested they would, if they were to both default. The drop will not be greater than 2% or I’ll eat a rodent! :)

Also keep in mind that the initial drop that occurs with the NAR number is not permanent. Barring a scenario where defaults happen on an ongoing basis, your return numbers will recover substantially over time.
Another thing to keep in mind is that 2 defaults so far out of 163 loans isn’t that many or that unusual……………..unless your overall portfolio is very young.

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Peter Renton April 26, 2012 at 9:00 pm

@Hopehickory, It sounds like your portfolio is relatively young so having two loans late out of 163 is not unusual at all as Dan points out. Your NAR will take a hit and it may even be more than 2% if both loans default, but it will certainly be less than a 5% hit. Make sure you check back in and tell us what your loss was (if indeed it gets that far), I would be curious to see Dan B sit down to dinner with a plate of curried rat. :-)

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Brady April 26, 2012 at 9:14 pm

@Hopehickory

Try and sell the notes on FOLIOfn at a discount and move on. Why wait for the bottom to fall out, especially if you have so little faith in them? Worth a try.

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hop hickory April 26, 2012 at 10:10 pm

Thanks for your input guys. I guess I don’t really have a handle as to how the APR is calculated. I was just subtracting the principle left on the loans from my gains. My portfolio is about 4 months old. As far as selling notes in Folio, I haven’t signed up yet but I thought you couldn’t sell notes that were sent to collections, which my two late loans were.

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