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In LendingClub’s most recent 8-K filing, the online lender projected significantly increased loan loss rates for all tranches of the portfolio. While all tranches are showing increase projected losses, the E-rated loans are showing projected losses going from 10.56% to 14.12%, an increase of 3.56%. For those unfamiliar with these number, that is a significant increase.
Disconnect Between Underwriting and Risk Assumption
What many observers of the online or peer-to-peer lending model have started to realize is that there is a inherent disconnect between the entity originating and underwriting the personal loans and the entities assuming the risk of the loans. Specifically, LendingClub gets paid when they originate a loan and when they take a servicing fee to service the loan after origination. The company takes no balance sheet risk, offloading the risk of loan losses to investors such as private individuals, investment firms, and banks.
Examining motivations of the parties involved in these transactions, you can immediately see that LendingClub is financially motivated to make loans regardless of risk – the get paid to originate loans and to service loans, but take no downside risk. This would appear to be a fundamentally flawed model.
What This Means for Borrowers
For borrowers considering a loan from a LendingClub, Prosper, or similar lender, understanding the motivations of those involved in the loan are important. As a borrower, you must understand that these companies are solely financially motivated to issue a loan. Unlike traditional lenders, they are not considering the likelihood of repayment by the borrower – in other words, can the borrower truly afford the loan. Therefore, it is up to the borrower to determine if they can afford the loan or if they really need the loan. Another way to put it, just because you get approved for a loan from on of these companies does not mean that it is in your best financial interest to take the loan.
If you are in the market for a loan, make sure you consider all sides of the relationship you are entering into with your lender. Is the lender pushing you into a loan to make an origination fee, or is the lender working with you to try and understand if the loan makes sense for you, the borrower, and for the lender.
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Feel like you are stuck in a never ending cycle of making minimum monthly payments on your credit card debt? Don’t despair, debt consolidation loans may be able to help. It isn’t just your feeling stuck though. When running the actual numbers for making the minimum monthly payment on credit card debt, you are literally stuck in a cycle that will take decades to get out of! Using Bankrate.com’s Minimum Payment Calculator, we can determine how long it will take to pay off your credit card debt and how much it will cost you.
True Cost of Making Minimum Monthly Payments
Let’s say you have $5,000 in credit card debt and the interest rate on your credit card is 22% (which is about the average for a non-prime credit card at the time of this publication). By only making the minimum monthly payment on that credit card, it will end up taking you 281 months to payoff the balance. By the way, 281 months is 23 YEARS! Further, you will end up paying $8,527 in interest on the loan. Let’s all agree, this is crazy.
How Debt Consolidation Loans Work
So, what are your choices? For many, debt consolidation loans may be the answer. The difference in debt consolidation loans from credit card debt is that the debt consolidation loan attaches a fixed term for the repayment of the debt. For instance, you may agree to a 24-month term, 36-month term, or even 48-month term to repay the amount owed.
Let’s go back to the same hypothetical $5,000 in credit card debt. Using a 36-month term on a personal loan from Patriot, you would end up paying $3,040 in interest and being debt free in 3 years. Compared to making the minimum monthly payment on your credit card, you save $5,507 in interest and are debt free 20 years sooner. Enter into the loan today and be paid off in 2018 verse 2038. How does that sound?
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The third in our series on financial literacy and understanding personal loans, this post will cover credit risk. Why is credit risk important? Well it is important to understand that loans have some risks for both the borrower and lender. The borrower takes on the obligation of paying back the loan while the lender takes on the risk of the borrower’s non-payment.
How to Assess Credit Risk for Personal Loans
When applying for a loan, developing your budget so that you know if you can afford a loan is critical. From there, looking at a series of factors can be helpful in determining the risk of a loan. For instance, looking at Ability to Repay (ATR). ATR analysis is often based on your DTI – debt to income ratio (your expenses compared to your income). Start by making a list of all of your recurring monthly expenses (such as your rent or mortgage, your car payment, etc.). Then, add in your take home pay from work and any other sources of income. By testing the DTI, both you and a lender can understand if you can afford the payment.
Like factoring in your DTI, using a lender that checks your credit report is important. By checking the credit report, the lender and the borrower can both be sure to know the full picture of the borrowers credit profile. You will also want to look at the payment amounts and terms. As we have written before, installment loans are easier to budget because they have a fixed payment amount. That is, you can budget in the same payment amount every month and know if you can afford the payment. Compare that to a credit card where you have to make a minimum monthly payment which changes over time.
Learn More About Credit Risk
The American Financial Services Association created Personal Loan
s 101: Understanding Credit Risk to help you better understand the risks on both sides associated with loans. Use this resource before entering into a personal loan to make sure you understand your obligations.
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Continuing in our series of financial education posts, we are focusing in this post on APR. In the context of personal loans, APR, or Annual Percentage Rate, is the calculation that the Truth in Lending Act defines as the cost of credit expressed as a yearly interest rate. Importantly, APR includes the interest rate plus any other fees or costs such as origination fees and processing fees.
When you are reviewing your personal loan documents, the Truth in Lending Act actually requires that the lender provide certain information. The loan must disclose the APR, the Amount Financed, the Finance Charge, and the Total Payments.
While APR can be a good guideline for understanding the costs associated with your loan, it is important to use it by comparing apples to apples. For instance, the APR on a 30-year mortgage allows you to compare loans from different mortgage lenders when one has higher interest rates but lower fees, etc.
So, before entering into a loan, here are a few things to consider:
- Check the APR, but understand how the interest rate, the associated costs and fees, and the term of the loan impact the APR calculation. Remember, APR is helpful in comparing different personal loan options and can help you make an apples to apples comparison. APR is not good for comparing different loans when the terms or amounts are vastly different.
- MAKE A BUDGET! We can’t emphasize this enough. Don’t rely on your lender alone to determine if you can afford the loan payments. Look at your gross monthly income, your net monthly income (after taxes), and your fixed monthly payments. After that, you need to be honest with yourself in terms of how much remaining disposable income you have each month.
- Borrow what you need when you need it, but only after consideration of all factors. Personal loans can be very helpful, but make sure you are using the loan for the right reasons.
- Don’t sign a loan until you understand the terms and conditions and the obligations you will have after entering into the loan agreement. It is always appropriate to ask questions if you are not sure about some factor. Highly rated loan companies build trust over time by working with their customers to understand each customers unique financial needs. Make sure the loan company you work with is willing to understand your financial situation.
For more on APR, click here to download the American Financial Services Association brochure entitled Personal Loans 101: Understanding APR.
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Personal loans are a great option because they provide simple terms, but it is important to understand the commitment you are making by entering into the agreement for the loan. The American Financial Services Association has produced an 8-page brochure that gives you a basic understanding of how personal loans work, a worksheet for calculating whether you can afford a loan, and the key terms to know.
The AFSA brochure gives you a series of questions to understand:
- Is a personal loan right for me?
- How do I know if I can afford a loan?
- What happens when I apply for a loan?
- What happens if I am late with a payment?
- What terms of financing should I understand before taking out a loan?
- Which laws exist to protect me?
By working through these questions before you enter into a loan, you will be better equipped to handle the loan and ultimately pay off the loan as planned. Also, the brochure provides borrowers with some of the key terms to know before entering into a loan:
Amount Financed – This is the total dollar amount of the credit that is provided to you as the borrower. This could be in the form of money paid to you, a credit line available to you, or financing for a purchase.
Annual Percentage Rate “APR” – This is a the measure of the cost of credit as calculated on an annual basis. We have another write-up entirely on understanding APR.
Finance Charge – This is the dollar amount you pay to use the credit.
Length of Term – Typically, personal loans have fixed monthly payments for a fixed term. This total number of scheduled payments or how long you have to pay the credit obligation.
Late Payment Fee – A fee that is charged when payment is made after your due date.
Monthly Payment Amount – The dollar amount due each month to repay the loan. Before entering into a personal loan, it is highly recommended that you make a budget. You need to determine if your monthly payment is affordable to you based on your monthly net income, your fixed monthly payments, and your disposable income requirements.
In any situation, make sure you work with a loan company that is willing to help you understand your loan before agreeing to the terms. Remember, it is always a good idea to ask questions before than after!
Click here to download Personal Loans 101: Understanding Personal Loans .
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