Recently, Harmoney announced details of a new fee regime for Lenders on their P2P consumer debt platform. Rather than charge a Service Fee of 1.25% of borrower payments (made up of principal and interest), the new system charges a percentage of interest collected. They will use a tiered scale and charge small investors more than larger investors. The fee will start at 20% of interest collected for investors with less than $10,000 of principal and drop to 15% for investors with more than $50,000 (and those in between will pay 17.5%). Most investors will fall in the 20% tier. This change will only affect new loans going forward.
Initial Analysis — Focus on Harmoney Fee Revenue
For simplification, imagine a small investor with a single loan of $10,000 with a 60 month term1. It has a C3 grade, so a 20.82% APR for the borrower. The monthly payment is $269.52. Under the old fee regime, Harmoney would keep 1.25% of the monthly payment, or a constant $3.37 each month, for a total over the 60 months of $202.
Under the new regime the Lender Fee will vary each month as the interest component of the monthly payment decreases. Over the 60 month term, Harmoney keeps as Lender Fee revenue a total of $1,234. This is a 6.1x increase in fee revenue for Harmoney. The magnitude of this increase will vary depending on loan term and interest rate. A cursory check of my spreadsheet model shows that the magnitude increase in fees is between 2.2x and 9.1x.
In this example 20.82% 60 month loan, after the 1.25% Service Fee under the old regime, the investor would be left with an IRR or Internal Rate of Return of 20.22%. Under the new Lender Fee regime, the Investor would be left with an IRR of just 16.66%, or 3.56% less than they were earning on the old regime.
Another concern is that the Lender Fee is heavily front loaded, like interest. In this example, the sum of the Lender Fee for just the first six months is $203, so Harmoney would recoup as much in Lender Fees in six months as it would take to make over the entire 60 month term under the old regime. Seeing as loans are most likely to default between 6 and 18 months, under the new system Harmoney will have already made their Lender Fee revenue equivalent to the old scheme in those first 6 months, so will they still have the incentive to chase up defaulting borrowers? Or, might they still be incentivised to rewrite the loan to stretch out the term, and earn more of those tasty front loaded revenues?
This first basic analysis above told me that the new Lender Fee regime is not an improvement for anyone other than Harmoney. I only looked at the 20% tier because that’s where my account falls. I’m guessing that institutional investors on the platform have even lower Lender Fee tiers than 15%.
A change of thought — Another way of approaching these changes
Well, my aversion to the new regime has now softened upon further analysis. When I initially wrote the text above, I could only see that Harmoney has increased fees for lenders. The increase for some grades appeared to be 800%. After doing more thinking and background reading, I’ll try to hypothesise what I think has happened.
Harmoney used to charge a platform fee to the borrower of between 2% and 6% of the loan amount, depending on the risk grade. They saw potential trouble with the Commerce Commission over this fee and changed it to a one-off flat fee of $375. I believe the recent changes may be part of a multi-step process to recoup lost revenue from this change.
First, they inexplicably put up interest rates in December 2015. Now they have replaced the Service fee with a much larger Lender Fee to take that added interest income off the lenders. I now believe that the combination of these two changes will roughly restore their revenue to what it was before and at the same time remove the complaints about rewrite driven early repayments and the double dipping on fees.
I’m going to analyse the situation as one package of changes, an increase in Lender Fee coupled with an increase in Interest Rates for grades C1 and greater, even though they happened at different times.
How are Investor returns affected?
Most investors will only ever look at the headline interest rates that borrowers pay.
In the initial analysis above, I focused on increased fee revenue for Harmoney which may not be fair if they are trying to replace their former platform fee paid by borrowers. Now I just want to look at effects on investor returns.
The two regimes we are now looking at affect investor returns in slightly different ways. Previously the 1.25% fee on principal meant that the faster the loan was paid back, the larger the bite out of annual interest taken by the fee. Now that the Lender fee is 20% of interest payments only, the speed at which a loan is paid back has no effect on the annual return.
This figure shows returns by credit grade after Harmoney charges either a Service or Lender Fee to an investor. Click for a larger version hosted at Google Docs where you can hover your pointer to see values.
Line 1. Old regime no early prepayments, shows the investor return by credit grade back before December 2015. Returns are adjusted for the 1.25% service fee.
Line 2. New regime, shows the investor return by credit grade for the current (May 2016) rates and adjusted for the new 20% tier Lender Fee. As you can see, investors are better off for grades D2 – F1. We can’t stop here however because remember that early repayments decrease returns under the old Service Fee regime, but returns are unaffected under the new regime.
The unconnected dots for Lines 3, 4, and 5 show the returns when a loan is paid off early in either month 12, 6, or 3. I didn’t calculate every point, but imagine the blue Line 1 shifts down to the green dots for Line 4 representing a loan fully paid off in month 6. You’ll see that the new regime is not far off the old, and is an improvement for even more of the curve. Results seen over the last twelve months tell us clearly that many borrowers will pay off their loans early. Thus, Line 1 in the graph above was only a best case return.
Remember that under the new regime, the red Line 2 never shifts. Take the headline rate and take off the 20% (or 17.5% or 15%) Lender Fee to calculate your return after fees. It will no longer matter how quickly the loan is repaid because there will no longer be a fee on the return of principal.
The borrower pays the rate shown by the blue line, New APR. The investor receives the rate shown by whichever tier the lender falls when the order is placed. Harmoney will earn the rate in between the New APR line and whichever Tier applies.
When the increase in interest rates charged and likelihood of early repayment are taken into account, the effect of the change to a Lender Fee doesn’t look that dramatic for investors.
The structure of payments has changed. Where the fee before was on both interest and principal, now the fee is on interest only.
Investors used to receive constant monthly payments. Now that the fee is tied to interest, the fee is larger at the beginning and smaller at the end of the loan. Payments to investors will now be smaller at the beginning and larger at the end, making the “payback” period or “duration” of the investment greater. This does increase risk at all grades.
Suppose I held $100 in a 9.99% 36 month loan that made three payments and was then later written off. Under the old regime, those three payments after fees would be $9.56 while under the new regime, they would only be $9.19. In both situations the principal written off would be the same, but under the old regime more interest would be received up front. For some grades the higher interest rates probably do compensate for some of this added risk however.
I think the biggest advantage of the new regime is it settles the controversy over rewrite driven early repayments and double-dipping on fees. Harmoney refers to the issue in their FAQ about the changes.
Why is the new fee structure being introduced?
The new pricing structure is being put into place as a way to keep our interests closely aligned with Lenders while allowing us to operate a sustainable business.
I haven’t decided yet if the changes will cause me to alter my investing strategy after the new regime begins in June. I had already slowed my deposits of new funds into my account recently. The returns for the highest risk grades are majorly affected however. I had already stopped investing in those grades most affected, F2-F5, so I don’t foresee needing to make any big changes.
Are there any other effects I have missed?
- In this ideal scenario there are no defaults or early payments. Also note I would never advocate investing $10,000 in a single loan, so if that bothers you, think of this example as investing $50 each in 200 different C3 loans. ↩