You may have wondered, 'Why shouldn’t I just invest in the loans with the highest interest rates?'.
We thought it might be helpful to consider why a lender would, at one extreme, invest in an A loan (with a low interest rate) versus a G loan (with a high interest rate), the other extreme.
The letter grades that are assigned to loans indicate the expected risk of the loan. A loans have the lowest expected risk of loss and therefore pay the lender the lowest interest rate. On the other hand, G loans have the highest expected risk of loss. Accordingly, G loans pay the highest interest rate in order to compensate lenders for the increased risk relative to an A loan.
A loans often have a relatively low loan to value (LTV). Additionally, the value tends to be based on a more reliable (or objective) data source such as an appraisal (completed by a third party) as opposed to the borrower’s opinion of sales comparables. Most importantly, A loans often have a first lien on the underlying asset. Consequently, if something goes wrong and the borrower defaults, lenders investing in the A loan will be paid first as there are no other lenders ahead of them.
At the other end of the spectrum are G loans. These loans are the riskiest loans that GROUNDFLOOR lenders can invest in. They typically have a high LTV - often greater than 75%. As opposed to A loans, the value is often based on a more subjective data source such as the borrower’s opinion of sales comparables. In particular, lenders investing in “G” loans are often in second position meaning that there are other lenders in the deal (such as a traditional bank loan) that will be paid before GROUNDFLOOR lenders. So if something goes wrong, those lenders will only be paid after the senior lender. If the borrower defaults, and the senior lender forecloses, they will attempt to recoup their capital with little to no consideration for the junior lenders.
There is risk associated with any loan, which is why it’s important to diversify and invest in many loans rather than putting all your eggs in one basket.