When you login to your account at Lending Club, the biggest thing that jumps out is your posted rate of return, or Net Annualized Return (NAR).
A lot of people in the lending community don’t like using NAR to calculate their returns, but it isn’t an incorrect methodology. In fact, it’s actually a solid way to think about how well Lending Club notes are performing, but it does tend to present the rosiest version of the truth because of what it includes and doesn’t include.
NAR effectively looks at your earnings vs. the money you have invested in notes. Lending Club defines earnings as earned interest plus late fees, minus service fees and charged off notes because of defaults. This sounds like the right way to think about it – it’s probably how you measure the performance in your brokerage account for example – but this methodology ends up excluding a few different important factors and ignores some important elements specific to P2P Lending as an asset class. Additionally, it’s important to understand NAR looks at a prior time frame, and isn’t useful for estimating future returns.
Unless your account is particularly mature, you will most likely find that your NAR will fall as time goes on, and this is one of the big criticism’s people in the lending community have against it as a metric to measure returns. The reason is that as your account ages, some notes will surely default, and as they default, they will start to take their toll on the NAR calculation. In other words, if you were to use a historical formula to look at your brokerage account, that might be fair because you can’t possibly predict the future – previous performance isn’t an indication of future returns, remember? But with loans, there tends to be a known, statistically significant default curve that is very much expected. So depending on the age of your account, NAR is almost certainly an inflated view of how you are doing. To be fair, I think Lending Club is pretty up front about this, and takes pains to estimate your default rate on each order and clarify that you shouldn’t be using NAR to estimate future returns – just make sure you heed that advice!
Additionally, NAR has a few other blind spots:
The exact formula Lending Club uses to calculate NAR is as follows:
Source: Lending Club Jan 2014
In Excel, you can calculate Net Annualized Returns using the following formula:
Using the same layout as the table below, paste the right values from your account statements into the appropriate, labeled cells and then paste the formula above into the cell labeled ‘NAR’. I’ve given some example values for reference.
Adjusted NAR is a basically a metric that Lending Club provides that tries to estimate future returns by applying a discount factor to NAR as notes enter a grace period and various late stages. Lending Club has well established figures on the likelihood of a note that enters a grace period, or any other late stage, to default. So for example, if we look at the figure below, we can see that Lending Club borrowers who enter a grace period have a 23% chance of being charged off. So, for those notes, we can take the current value of that note (remaining principle plus interest yet to be paid), and multiply it by 77%, or 100% of its value minus it’s 23% propensity to be worth nothing. If we do this for each note, and apply the right discount factor based on that note’s stage of lateness, we can reduce NAR to an adjusted figure that tries to take into the account the impact of future defaults. Lending Club provides the graph below to explain how these figures tend to differ, and you can see that Adjusted NAR tends to be more stable over time compared to NAR, and that’s a good thing for investors. But while this all sounds pretty good, it’s still a poor metric to use in tracking your account in my opinion.
Source: Lending Club Jan 2014
For one, Adjusted NAR continues to exclude all the factors we noted above, with the exception of defaults over time. But idle cash and the impact of trading activity is still missing from our view. Finally, Adjusted NAR doesn’t take into account late fees to be paid by non-defaulting loans. Given all this, lenders should really use the XIRR methodology to calculate their Lending Club returns. This is the way that I and others in the lending community tend to look at when figuring returns because it does account for the impact of idle cash, as well as activity from your trading account. Not only that, but you can apply your own discount methodology, similar to Adjusted NAR to estimate future returns.