Are all Prosper loans within a credit grade created equal?

The easiest way to categorize risk is by credit grade. At Prosper you can search and filter loans by credit grade. Many lenders, including me, pay particular attention to higher credit grades while excluding the lowest credit grades completely.

Today we ask the question: Are all loans within a credit grade created equal?

Let's start with some statistics. The following are the average lender rates by credit grade. Note, this is not the actual interest earned by the lender, just the rate the borrower agrees to pay the lender at the time the loan is made.

Credit GradeInterest

Here are the same statistics for all loans that are current:

Credit GradeInterest

Now, lets take a look at the numbers for the loans that have defaulted:

Credit GradeInterestPercent Above Average LoansPercent Above Current Loans
AAnot enough datan/an/a

So, what do these numbers tell us? Well, if we look at loans in the B through HR categories, the loans that defaulted had a 1.7% through 2.6% higher interest on average than other loans in that credit grade. What this means is that prior to defaulting lenders considered these loans a higher risk and didn't bid down the interest rate as low as they did for other loans.

The difference is even more pronounced when you look at the difference in interest rates between loans that are current versus loans that have defaulted. Lenders put as much as a 3.74% risk premium on loans that ended up defaulting - clearly lenders were seeing something they didn't like in the listings compared to other listings of the same credit grade.

There are two things that we should learn from this data. The first is that it is probably not a good strategy to look for the highest rates in each credit grade. If you consistently seek out the highest interest rates in each credit grade then you are going to have a higher rate of defaults then if you were sticking to loans that are closer to average or below average for those credit grades.

The second lesson that we can learn from this data is that there are other important pieces of information when looking at a loan. It is important to look at the whole picture including number of delinquencies, debt to income levels, income, public records, and revolving credit balance. Basically you want to ask yourself questions like:
  • Does this person have enough resources to pay back this loan?
  • Does their past credit history show they can be trusted with credit?
  • Does their purpose for the loan make sense to me?

What you will find is that some lenders will stick to the higher credit grades to lower their risk, but then they seek out the loans within that credit grade that pay the highest interest rate to the exclusion of all other criteria. Some lenders, for example, might set a standing order that would bid on loans only if they are at a higher than average % for that credit grade. Then they wonder why they are having a higher than average default rate in their portfolio. The answer is that lenders have allowed them to close at higher interest rates because they correctly assessed that they were higher risk loans in spite of their good credit grade.