Total ROI – A Look At Diminishing Returns

There has always been divided discussion on how to calculate annual ROI.  LendStats takes the equation for ROI and substitutes interest / rate for principal.  This has the advantage of being simple and also capturing uniform ROI information across all loan terms (36 vs 60 month). Nickel Steamroller uses this method.

Another ROI metric that does not get much mention is total ROI, or the total amount of interest earned if you did not reinvest and allowed loans to mature. It has one unique advantage… it’s not a number that leaves much to dispute.

The highest rate of return you will earn on a note is the first payment, from that point forward your return diminishes. That’s worth repeating! The highest rate of return you will ever see on a note is the first payment.

Why you might ask? Take a look at this loan repayment chart

Loan payment schedule of a 1-year, fixed-size ...
Image via Wikipedia

Everyone knows (or should know) when you buy a house, the first few years of payments are mostly interest. Figuratively speaking, you put a small dent in the principal.  This is where the banks make the most money on your loan. Interest is the amount of money you pay for the privilege to borrow, and in the lender’s eyes, the more the better. This is why banks rely on people refinancing loans every 7 or so years, and also why they end up selling the loans to the government after they’ve held the loan for a short period (relatively speaking).  As the amount of interest payment decrease, the monthly ROI decreases as well.

The chart tells an interesting story and it’s important to understand that all of the ROI numbers advertised by LendingcClub and Prosper are largely the results of these first few mostly interest payments.  You have to constantly reinvest your money, or you are reducing your interest payments. Even a week of idle cash will have an impact, albeit small, on your real ROI.

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This table helps you understand what your annualized returns on LendingClub would be if you purchased loans and then let them sit to maturity. It does not paint a pretty picture, and goes to show how vital the first loan repayments are for your ROI and the need to constantly reinvest.  This table also helps illustrate if you wish you end your P2P account, letting loans mature is not wise. I would be better to put all the notes on the secondary market.

I wonder if people will try to treat the secondary markets like the banks treat Fannie and Freddie, simply taking the initial interest payments then dumping the loan leaving much of the principle intact?  I believe the 1% selling fee is enough to discourage this, but if that fee was ever reduced you can be sure this type of activity would ensue.  Another thing to consider is that unless a note is heavily discounted, buying aged notes doesn’t make the most sense. There is little interest left and little return to be had.


7 thoughts on “Total ROI – A Look At Diminishing Returns

  1. Michael,

    Interesting analysis. There is one thing that I would like to clarify about these ROI numbers. Is this assuming that all payments are held in cash earning 0% or is this ignoring cash and just calculating the ROI based on the balance of the loan itself?

    1. This assumes every payment is held in cash earning 0%. I consider the entire principal your initial investment, and that is kept constant over the entire investment period.

      It would be like if I invested $10,000 in A loans. I walk away and forget about them, coming back in 3 years I could expect my compound annualized rate over three years to be about 1.09%

      But you raise a good point. Maybe Lending Club only uses the principal that is invested to calculate the ROI. This would produce a very different ROI, and fact one that looks much more favorable and in my opinion does not reflect reality.

        1. You are correct Peter. The point I want to illustrate is that you can not simply park your money like you could with a 5 year CD, treasuries, mutual funds, or even a dividend paying stock. You must actively manage your p2p accounts or your ROI will erode dramatically with time. I don’t really see a problem with this though, it is a price in terms of time I am willing to pay for lower volatility.

          1. Micheal, I was doing a little brainstorming here and based on the information above, what we need is way to set a goal for all loans in a portfolio. Like, once your loans reach a certain ratio of principle to interest it raises a sell flag. Just a thought from a newbie.

            Thanks for all the great info!

          2. Not sure if I could go that route. Typically loans get “safer” as they age. What I could add is the ratio of expected payments (age * monthly payment) to total payments. Would you like to see that?

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