Monday, February 22, 2010

How is Net Annualized Return calculated for Lending Club?

Lending Club uses a rather sophisticated formula for calculating Net Annualized Return for an investor's portfolio of loans. It has some complexity to it that is not easy to explain, but the basic answer is that you need to keep reinvesting to keep your net annualized return up. Otherwise, you quickly accumulate cash that earns no interest.

Put another way, the borrower only pays interest on the principal remaining, so as the principal remaining declines over the 3-year term, the interest paid each month declines as the amount of principal repaid on the loan rises rises each month.

Basically, the Net Annualized Return calculation is based on the principal REMAINING at the start of the period (month), which excludes any principle repaid in prior months.

Another way of thinking about it is that it is the mirror image of compound interest, but in a negative direction rather than a positive direction. But it is only negative if you fail to reinvest in a timely manner. That does not mean you need to reinvest every single month, but I would advise reinvesting at least quarterly. It is mostly a matter of how much attention you want to give your account.

Another way to look at monthly principal repayment (and interest) is simply as cash flow. Sure, you can invest or reinvest that cash flow, but you may also have other uses for it such as spending it for expenses or other purchases. For example, if you are wealthy or retired, you could invest the money you need to live over the next three years and then simply "clip coupons" and live off the monthly cash flow.

Either way, Lending Club offers you flexibility with strong cash flow, either to use it as cash or reinvest for compounded returns.

-- Jack Krupansky

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