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.
