Initially all notes issued through lending club were repaid over a period of 3 years. On May 7, 2010 LendingClub began issuing notes with 5 year terms. All of these notes have standard, mortgage style amortization with level monthly debt service payments. The new 5 year notes pay interest rates of 2.23% - 4.60% higher than 3 year notes. Additionally, the impact of the 1.00% service fee is significantly reduced on notes with a 5 year term. For 3 year notes the service fee reduces net annualized returns by 0.71%, however, for the 5 year notes the service fee only reduces net annualized returns by 0.45%. There are, however, increased risks associated with the longer term that I will explain below.
Some of the risks are quite obvious. For example, having your capital tied up for a greater term means that it is more likely that you will need that money for some other purpose while it is tied up with the LendingClub note. This other purpose could be making a purchase, or it could also be another, higher yielding investment opportunity. This risk is substantially mitigated by the added liquidity of the trading platform. If an investor needs to liquidate their notes they can sell them rather quickly for a 1.00% service fee plus whatever discount they must offer in order to make the sale price attractive. However, there is still some degree of risk if an attractive opportunity becomes available to all investors at the same time (for example a better peer-to-peer lending platform or a raise in interest rates for new loans on LendingClub) then sellers will forced to reduce the prices of their notes in order to find buyers.
Another seemingly obvious risk is interest rate/ inflation risk. As with any fixed rate security, real returns are subject to fluctuations in the interest rate environment. If inflation increases or if the prevailing interest rates rise over the term of the loan, the underlying security will become less valuable. Conversely, if inflation rates fall the underlying security will appreciate. However, this still poses a risk to investors because it will make it more difficult for borrowers to repay their loans and it will increase the likelihood of default. The possibility of interest rate fluctuations and inflation add risk to the longer term notes and therefore the interest rates paid by borrowers must be higher in order to compensate the investor.
One risk that is less commonly known by LendingClub investors has to do with tax law. For a 3 year note, if the note is delinquent at the end of the term LendingClub will still make payments to the investors on any payments they collect from the borrowers until 5 years from the initial issuance date. However, if a 5 year note is delinquent at the end of its term then LendingClub will not make any future payments to investors even if they are able to collect from the borrowers. The prospectus explains this policy as a tax issue. Apparently, if LendingClub makes distributions to investors more than 5 years after the initial issuance date then they cannot write off the interest payments and must pay taxes on them even though they are distributing the payments to the investors. They do not go into any detail about the reason for this interpretation of the tax code. Presently, none of the 5 year notes have reached their final maturity yet so we don't know what percentage of them are likely to be delinquent on their final payment. However, this certainly adds a degree of risk to the notes that the investor must be compensated for through higher interest rates.
Finally, borrowers who select the 5 year term are likely less able to repay the loan than borrowers who select the 3 year term. Borrowers are informed during the application process that they will pay a higher interest rate for a 5 year loan than a 3 year loan. Therefore, by selecting the 5 year loan it is probably that they are unable to make the higher payments on a 3 year loan. We can assume that the loan payments for 5 year borrowers, on average, have a bigger impact on the borrowers day-to-day finances and pose a greater risk to their solvency. We can also assume that by electing to take the higher interest rate of a 5 year loan, the borrowers have a longer term debt problem rather than a short term cash flow problem.
Ultimately, it is up to the individual investor to decide whether the increased interest payment adequately compensates for the increased risk of a 5 year loan. Personally, I believe that it does and the majority of my portfolio is comprised of 5 year loans. Please let me know your thoughts below though.
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