How To Use The Bad-Debt Rate

Lenders can use the bad-debt rate to see how low bad debts have been in the past on a P2P lending webste.

An average annual bad-debt rate of 0.5% during a moderate or good economic backdrop is very low, for example. Any bank would be chuffed to have such a rate.

If bad debts based on the year of loan issue frequently weigh in below 1%, this is also excellent. (See the section “Lifetime bad debts” in What Is The “Bad-Debt Rate”? to learn more about this measure of bad debts.)

Most lenders should probably just be lending through P2P lending companies that offer bad-debt rates roughly in this ballpark. It can be a sign that they have strict, disciplined criteria.

Projecting the future

The actual bad-debt rate doesn't tell you what your bad debts will be in the future. It's historical.

Bad-debt rates can and almost certainly will rise dramatically in a recession. However, a very low historical rate is a signal that bad debts will be well contained even in tough times.

The higher the bad-debt rate in good times, the more you can expect them to multiply in bad times.

So, low annual bad-debt rates of 0.5% might go up, say, five-fold to 2.5%, still leaving you with a profit, while bad-debt rates of 3% might go up seven-fold to 21%, giving you a big loss!

Compare bad-debt rates to each other

You can also compare one P2P lending company's bad-debt rate to another. Particularly to other similar P2P lending options, e.g. personal loans compared to personal loans.

Short histories are less useful

A very limited history is not much use.

You need to see when the P2P lending company started matching loans and get an idea how many loans have been matched.

You should also try to find out or estimate how many loans have run their course, so you can estimate how low bad debts are over the full life of the loans.

Take short records with a pinch of salt, while triple checking all other possible measures of the P2P lending opportunity's safety. If you can't satisfy yourself that you understand the risks fully, don't lend.

It's a bit late for that!

Some P2P lending companies will seriously loosen their borrower selection standards when they're desperate to keep growing, but there aren't enough high-quality borrowers to help them do so.

The historical bad-debt rate can't tell you whether a P2P lending company is going down this dark path. At least, it can't really tell you that until it's too late.

This is because it takes several years before that sort of pattern becomes clear in the bad-debt rate, by which point you have already suffered the higher bad debts yourself.

What you can do is look to see if the P2P lending company has started withholding bad-debt statistics that it used to publish on its website or used to provide to 4thWay®. That is a sign that it is slackening standards but doesn't want you – or 4thWay® – to know about it.

A similar sign is if it changes its definition of “bad debt”. Perhaps it used to define it as “loans that are 120 days late”, but now it is a more vague definition, e.g. “loans that we believe have no prospect of being repaid”.

Aside from that, you'll need to look to other signs to get early warning of weakened standards. This could be a rapidly rising number of loans that are being paid late, especially compared to similar competitors. Or the P2P lending company could have started to accept a much higher proportion of loans than it used to.

Sign up to our newsletter below for early warning that any of these and other signals of crashing standards are flashing red.

Read more: Are Bad Debt Forecasts Misleading?