Peer to Peer Lending - How Interest Rates are Set by Lending Club
With any investment or loan there needs to be an interest rate charged. Lending Club uses a formula that takes into account several factors, but it really begins with the assigning of a loan grade.
The first step in getting any peer to peer loan on Lending Club is borrowers must apply for a loan. Upon this request, Lending Club begins to evaluate the potential borrowers' credit standing. This information is taken and used to assign the borrower a loan grade. These grades range from A to G with A being the highest and G the lowest. To further narrow down grades, each letter grade has sub classes. These are numbered from 1 to 5 with 1 as the highest. These loan grades will then be used in every part of the Lending Clubs formula for calculating interest rates.
The formula is made up of two distinct parts. They are the based rate and the adjustment for risk and volatility. The sum of these equals the interest rate charged.
The base rate is the interest rate charged on every loan. For most peer to peer loans on Lending Club it is 9.05%, but can be different for the A grade loans. Grades A1, A2, and A3 get a base rate of 7.05%. A4 and A5 get a base rate of 8.05%. This lower rate represents the decreased risk for this category of borrower.
The second part, the adjustment for risk and volatility, is a bit more complex. It begins by using the grade assigned to calculate an 'assumed default rate.' This assumed default rate is then doubled and is used as the adjustment for risk and volatility. This creates an interest that is increasingly proportionate to the default risk of the borrower.
To further explain lets calculate the interest rate on a peer to peer loan from Lending Club. If a borrower is assigned a loan grade of C3, the base rate is 9.05%. The assumed default rate calculated by Lending Club is 2.05%. This makes the adjustment for risk and volatility 4.10%. Now the base rate plus the adjustment for risk and volatility equals an interest rate of 13.15%.
Lending Club does reserve the right to change both the base rate and the adjustment for risk and volatility. This only applies to incoming loans not to preexisting ones. This flexibility allows Lending Club to adjust for the market conditions and ensures the loans stay attractive to both borrowers and investors.
These rates no matter how they are assigned are attractive to both borrowers and lenders. The rates are usually lower than several other options of funding for borrowers and lenders get a rate of return normally above 10%.
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