A Higher Rate Is Not a Higher Return After Expected Loss

What expected loss actually measures

A borrower can default and still repay part of the debt through recovery. Another borrower can repay in full. Expected loss allows for both possibilities by weighting the loss that would follow a default by the chance that it happens. It is a way of putting a credit cost into the comparison before either outcome is known.

The time period matters. If the comparison starts with an annual rate, the default probability and loss estimate should cover the same year. The formula first gives an amount in euros. Divide that amount by the starting investment to express the loss as a percentage that can be compared with the rate. A loss estimate for the full life of a multi-year loan cannot be subtracted directly from a one-year rate.

The three numbers behind expected loss

Probability of default explained. Probability of Default (PD) is the chance the borrower defaults within a specified period. The estimate can draw on the borrower’s cash flow, debt obligations and ability to meet scheduled payments. A credit grade can help put a borrower in context, but it does not by itself supply a numerical probability. The relationship between credit grades and interest rates is a separate question.

Loss Given Default (LGD) is the share of the exposure the lender expects to lose if default occurs. An asset pledged as collateral can reduce that loss if the lender has an enforceable claim and the asset brings in enough after recovery costs. The relevant figure is what the lender expects to recover, which can differ from the value recorded when the loan was made. That difference matters in crowdlending recoveries involving collateral.

What is exposure at default?

Exposure at Default (EAD) is the amount at risk when the borrower defaults. For a simple funded claim, outstanding principal is the starting point. If the borrower has already repaid part of the principal, the amount exposed can be lower than the original investment. If principal is due in one payment at maturity, the full balance may remain exposed until then.

These ranges illustrate the method. They are neither historical platform figures nor estimates for Maclear claims.

How to compare loan interest rates by risk

How do you calculate expected loss on a loan?

Multiply PD × LGD × EAD to estimate expected loss in euros. Multiplying PD by LGD alone gives the expected loss as a share of the amount exposed at default. To subtract the loss from the quoted rate, divide the euro figure by the starting investment first. The two percentages have the same base only when exposure at default equals the starting investment.

This gives a simplified estimate of the risk-adjusted return on a loan. It answers a specific question about how much of the quoted rate remains after allowing for expected credit losses. Fees, taxes and the timing of payments can still change what the investor earns. Those are among the reasons a single rate is insufficient for comparing two offers.

Is a higher interest rate always a better investment?

No. A higher rate leaves more room to absorb a loss, but the expected loss can be larger than the extra interest. If two borrowers have similar chances of default, the comparison can turn on how much is likely to be recovered. A lower-rate claim can come out ahead when the difference in expected recoveries is large enough.

A worked example with two loan claims

Illustrative example, not Maclear’s actual figures. Assume two one-year claims of €1,000 each, with all principal due at maturity. Both have the same assumed probability of default. Claim A pays a higher nominal rate and has weaker collateral. Claim B pays less and has stronger collateral. For this simplified comparison, the loss estimate covers principal and the calculation excludes fees, taxes and any unpaid interest.

Claim A

1. Nominal annual rate: 16%.
2. Probability of default: 6% over one year.
3. Loss given default: 65% of the exposure.
4. Exposure at default: €1,000.
5. Expected loss: 6% × 65% = 3.9% of exposure. On €1,000, that is €39, or 3.9% of the starting investment.
6. Risk-adjusted rate: 16% − 3.9% = 12.1%.

Claim B

1. Nominal annual rate: 14%.
2. Probability of default: 6% over one year.
3. Loss given default: 20% of the exposure.
4. Exposure at default: €1,000.
5. Expected loss: 6% × 20% = 1.2% of exposure. On €1,000, that is €12, or 1.2% of the starting investment.
6. Risk-adjusted rate: 14% − 1.2% = 12.8%.

Claim A offers two percentage points more in scheduled interest. Its expected principal loss is 2.7 percentage points higher, leaving Claim B ahead by 0.7 percentage points in this model.

All figures are hypothetical. For an actual Maclear claim, use the project listing to check the rate, repayment schedule and collateral terms. Any probability of default or loss given default used in a comparison needs its own evidential basis.

Why collateral quality can change the comparison

Why does collateral quality change expected return?

Collateral can change what the lender recovers if a borrower defaults. In the example, the borrowers have the same assumed probability of default. Claim B comes out ahead because its lower loss given default means the lender expects to recover a greater share of the outstanding principal if repayment fails.

The result is sensitive to that recovery assumption. Suppose a review of Claim A’s collateral reduces its assumed loss given default from 65% to 50%. At the same 6% probability of default, its expected loss falls from 3.9% to 3.0%. Its risk-adjusted rate rises to 13.0%, just above Claim B’s 12.8%. The nominal rates have stayed the same. A 0.9-point change in expected loss was enough to reverse the initial 0.7-point lead.

That is why the estimate should reflect what the lender may actually recover. In Maclear listings, the collateral and the ratio of the loan amount to the asset’s value give context for that assessment. Recovery also depends on the price the asset can fetch, the costs of realising it and the lender’s rights to the proceeds.

What the calculation leaves open

Expected loss is useful when comparing assumptions across claims. An individual borrower may repay every euro or leave a shortfall much larger than the expected loss. Claim B’s €12 is an average implied by the assumptions. If it defaults and the assumed 20% loss applies, the principal shortfall would be €200. The impact of one default across several loan positions is a separate calculation.

The comparison is only as useful as its inputs. A small lead deserves a closer look if the collateral value is uncertain or there is little evidence for the default probability. Running the calculation with a lower recovery estimate shows how much of the apparent advantage depends on that assumption.

Expected loss is an average outcome across many similar loans, not a forecast for any single claim - a specific borrower can default or repay fully regardless of what the probability-weighted calculation shows.

Frequently asked questions

What is expected loss on a loan?

It is the probability-weighted credit loss over a specified period. Multiply the probability of default by the loss given default and the amount exposed to get a currency figure. For a comparison with an annual rate, use a one-year estimate and express it as a percentage of the starting investment.

Is a higher interest rate always a better investment?

No. A higher nominal rate can leave less after expected losses if the borrower is more likely to default or if recovery would be lower. The comparison depends on the size of the rate advantage and the size of the expected loss, measured over the same period and against the same investment base.

What is loss given default?

Loss given default is the share of the exposure the lender expects to lose if the borrower defaults. It accounts for amounts that might be recovered, including net proceeds from pledged assets. Weaker collateral can increase the expected loss if the asset would bring in less after recovery costs.

What is exposure at default?

Exposure at default is the amount still at risk when default occurs. For a funded claim, the principal balance may be smaller than the amount originally lent if the borrower has made repayments. Where all principal is due at maturity, the original balance may remain exposed until the final payment.

Does a low expected loss guarantee the loan will be repaid?

No. A low expected loss describes the average implied by the assumptions. A borrower can still default and leave a substantial shortfall, or repay in full. The figure helps compare credit risk across claims and gives no prediction of how much an individual borrower will ultimately repay.

The content of this article is provided for informational and educational purposes only. It does not constitute investment, financial, tax, or legal advice. Peer-to-peer (P2P) lending and crowdlending investments carry a risk of partial or total loss of capital. Past performance does not predict future results. Liquidity on a secondary market is not guaranteed. Readers are encouraged to conduct their own research and consult qualified advisors before making any financial decisions. The availability of products and services may be restricted in certain jurisdictions.