A lending return is the interest collected, less the share of principal lost to defaults after recoveries, less fees. Expected loss is the number the headline rate leaves out.
12 min read · Level 3
The most honest way to see a lending investment is as a return you are paid for carrying losses that have not happened yet. I think platforms that advertise the interest rate prominently and the expected loss quietly, or not at all, should be treated with suspicion, because the second number is the one that decides whether the first means anything.
A lending portfolio's return comes down to one line:
Net return = interest - expected loss - fees
Expected loss is three numbers multiplied:
Probability of default (PD) share of loans that fail in a year Loss given default (LGD) share of a defaulted loan not recovered Exposure at default (EAD) amount owed when the loan fails
Take 50,000 spread across 100 loans of 500 each, at 10% interest, with a 6% annual default rate, 20% recovered from defaulted loans, and a 1% annual platform fee. For simplicity, assume defaults happen at year end, after interest was paid.
Interest (10% of 50,000) 5,000 Expected loss: 6% x 80% x 50,000 -2,400 Platform fee (1% of 50,000) -500 Net 2,100 = 4.2%
The 10% headline became 4.2%. In reality defaults happen through the year, so some interest is never collected, and the real figure would be somewhat lower.
Recoveries also take time. The 600 recovered on 3,000 of defaulted loans might arrive over one to three years, which lowers the return further in time-adjusted terms.
Because the headline rate is the most visible number and the least useful one. Two platforms advertising 10% can deliver very different results depending on who they lend to and how well they recover bad loans.
It also shows how sensitive returns are to default rates. Lending returns have a fixed upside and a variable downside, so small changes in defaults move the net return a lot.
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The same portfolio in a recession. Defaults double to 12%, and recoveries fall to 10% as collateral values drop.
Interest 5,000 Expected loss: 12% x 90% x 50,000 -5,400 Platform fee -500 Net -900 = -1.8%
A portfolio that returned 4.2% in a normal year loses 1.8% in a bad one. The headline interest rate did not change at all.
Treating a platform's historical default rate as a stable number. Defaults cluster in downturns, and a record built in good years can understate losses when conditions change.
Multiply default rate by loss given default. Use recession-period figures where available, not just recent averages.
Include platform, servicing, early exit and fund management fees.
Double the default rate and cut recoveries, and see whether you can accept the result.
When comparing lending platforms or credit funds, or deciding whether a lending return compensates for the risk.
Do not treat the illustrative rates as typical for any platform. Real default and recovery rates vary widely by borrower type, platform and economic conditions.
Some peer-to-peer platforms operated provision funds intended to cover losses on defaulted loans. When defaults rose sharply, including during the COVID-19 period, several such funds proved insufficient, and investors experienced delays or losses despite marketing that had emphasised the protection.
A reserve fund sized for normal defaults is not a guarantee. Ask how large it is relative to losses in a recession.
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