Understanding how their portfolio performs is key for investors. In this tutorial, we will explain all you need to know about the internal rate of return (IRR).
What is the IRR?
The IRR is a metric used in finance to measure the profitability of potential investments and compare the attractiveness of each of them.
IRR is a time based concept. The IRR is the net annual return earned by the investor over a period of time and calculated on the basis of the incoming and outgoing cash flows. In the case of October loans, the IRR takes into account the initial investments realised, the monthly repayments and the potential defaults and express all these cash flows as an annual return. The IRR can be calculated for a particular loan but is a powerful metric to express the return of your portfolio as a whole, taking into account provisions and losses (in case of default).
Let's take an example: imagine that you lent €100 over 24 months and that at the end of this period you received a total amount of €106.81. The IRR estimates the annual rate that should be applied to the initial investment of 100€ to reach 106.81€, with monthly repayments accrued over two years. To do so, we have to take into account all future repayments, the date of these repayments and the date on which the initial investment was made. In our example, the IRR in this case is 6.61%.
⚠️ Don’t get confused. Common mistakes include:
- Thinking the IRR is equal to the nominal interest of a loan. These are two different things: the IRR of the October loan is not equal to its annual interest rate because the borrower repays the loan on a monthly basis (part of the principal and a part of the interest is amortised every month);
- Expressing the yield as the return of your global investment. This method is incomplete because it does not take the concept of compounding and the time into account.
- If you have reinvested your earnings, you have increased the value of your portfolio due to the interest earned on both the initial principal and accumulated interest. This compounding effect has to be reflected in the return calculation.
- Besides, if you calculate the return on a global basis, you will not get an annual rate, which means you will not be able to compare it with that of other financial products.
- “I don’t understand: I have losses but my IRR is still positive”: it is indeed totally possible! How? You may face losses because of a project in default and still have a positive IRR because the IRR takes into account future repayments (and thus interests received on ‘healthy’ loans cover the capital losses made on the project in default). Losses are a picture a T time and IRR takes into account future repayments.
Where can I find my IRR?
You can find your global IRR on the Summary tab of your Portfolio. Every time you lend to a new project, you receive repayments, you have a default and a provision is applied to your outstanding capital, this IRR is updated.
The IRR of each project is not displayed in the Portfolio but you can calculate it from using the repayment extract available on the Summary tab of your Portfolio. To download the Excel of your future and past repayments for all the projects you lent to, click on the “Export” button, above the Activity section. Learn more about the calculation of the IRR.
What is the difference between initial and actual IRR?
There are 2 IRRs in your portfolio:
- The initial IRR, which represents the annual return of your portfolio without any default or early repayment.
- The current IRR, which provides an adjusted view of your returns after defaults and early repayments.
This allows you to quickly see the impact of defaults or early repayments on the profitability of your Portfolio.