10 Things You Need To Know About Peer to Peer Lending

10 Things You Need To Know About Peer to Peer Lending (P2PL)

1)  P2PL is new and it’s anti-bank.  It’s hard to blame the folks protesting against banks.  I mean, they offer us loans at crappy rates and then they offer us crappy interest rates on our investments.  Peer to peer lending has only been around about 6 years, but it gives you the chance to play banker.  It offers borrowers a chance to get a lower rate than a bank would offer them, and it gives investors a chance to get a higher return than the bank is offering.  Of course, to get it, you have to take on the risk the bank was taking on before…


2) P2PL is available from several different companies, but the two largest are Prosper.com and Lendingclub.com.  There are significant differences between them.  Prosper is a bit older, Lending Club is now a bit bigger.  Prosper has you bid on the interest rates you’re willing to give a loan for.  Lending Club sets the rates for you.  I’ll be reviewing each in detail in future posts.

3) P2PL is changing.  Initial returns, predominantly on Prosper, were very disappointing, mostly because the default rates were astronomical, essentially around 40%.  It doesn’t really matter what interest rate you’re getting when you’re losing 40% of your principal on loans.  Beginning in Summer 2009, Prosper got their act cleaned up. Lending Club has also been continuously refining their model to reduce (but of course, not eliminate) defaults.  Looking at loans originating in the last six months of 2009, both Lending Club and Prosper have a default rate (including currently late loans) of 13.5%.   That’s not great, but at least it allows you to get a decent return.

4)  P2PL offers decent returns.  Using loans from that same time period, Prosper has had overall returns of 8.3% and Lending Club has had returns of 4.3%.  Considering current expected returns for other asset classes (stocks 5-9%, bonds 2-4%, and cash 0-1%), those returns look pretty good.  Now, averages aren’t everything.  If you look at the top ten lenders on Prosper, you see returns of 18-20%, and if you look at the bottom ten, they’ve lost up to a third of their money.

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5) You can’t believe everything they put on their websites.  Prosper boasts returns of 10.69%.  Lending Club boasts returns of 6-12%, and notes that no lender (investor) who has bought at least 800 notes (at least $20K) has had a negative return.  But if you look at returns from July 2009 to present from an objective source, you see returns of 9.2% for Prosper and 6.38% for Lending Club.  Those returns aren’t bad, but they’re not what they’re publishing, and because many of the loans are still new since both companies are rapidly growing (average loan age is ~ 10 months), chances are the final returns for those notes won’t be that high.

6) Interest rates are not expected returns.  Let’s compare Lending Club’s notes from 2009 with regard to initial interest rate and final return.  First, their A and B grade loans (good borrowers).  The interest rate was 10.68% on average, but the return (thus far) is 4.58%.  Quite a difference.  Let’s compare to their D, E, F, and G grade loans.  The average interest rate was 15.97%, but the return was only 3.96%.  It turns out it is a tricky game to set those interest rates right for the amount of risk being taken on.  Prosper’s data looks pretty similar with regards to initial interest rate.

7) Broad diversification is very important.  Since avoiding defaults is such an important part of P2PL, you want to buy a lot of notes.  You can spend as little as $25 per note, which makes it relatively easy to achieve broad diversification.  There’s no excuse not to.


8) Active management plays an important role in this investment.  Compared to buying a few index funds at Vanguard and rebalancing them once a year, P2PL is a lot more time-consuming.  Although there are a few ways to speed up the process, in essence you have to pick up the loans you want to invest in individually.  It turns out that some borrowers are more likely to default than others.  Some of that is priced in, but some of it isn’t.  Filtering through the offered loans to try to get a better return than average is time-consuming, but can be rewarding. Through Folio, you also have the opportunity to buy and sell notes.  Many investors sell off their notes at a discount once the borrower goes late on a payment for instance, or just because they need their money out of the investment before the term is up.  If you’ve ever wanted to run a mutual fund, here’s your chance.

9) Cash drag plays a real effect.  No matter how closely you watch it, there will be a drag on returns from the cash in your portfolio.  It takes time for you to choose loans acceptable to you and then for them to be approved.  Just like in a mutual fund, this will lower your returns, perhaps as much as 1%.  At least at Lending Club, you can fund your account using your credit card (for amounts between $250 and $5000 anyway) and use the float to your advantage to minimize the cash drag.

10) Low Correlation.  One of the real benefits of P2PL is the low correlation with my other investments.  While I suppose if the economy tanks stocks could go down at the same time my P2PL defaults go up, P2PL is such a different beast from my other asset classes that it ought to perform quite differently from both my equity investments and my other fixed income investments.

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I’ll have a few more posts coming up on this subject, including detailed reviews of both Lending Club and Prosper, as well as some tips on how to select notes with a lower risk of default than expected (leading to higher returns) and how to decide when to buy or sell notes on the secondary market.  In the meantime, if you’d like to get started, shoot me an email and I’ll send you a link that’ll be worth $100 to you if you invest at least $2500 with Lending Club.  Or just click on the ads on the page to learn more.  Like many ads on this website, I get money if you click on links and open an account.

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Comments

10 Things You Need To Know About Peer to Peer Lending — 13 Comments

  1. Great article. I’ve never really thought about this before. Pretty much a given that these people wouldn’t qualify for a regular bank loan.

  2. I’d also love to see more information about it from the perspective of borrowing money this way in addition to your other posts about lending the money. If I have good credit, would I still get the benefit of the lower rates?

  3. Yes, you can get fairly low rates, but only in comparison to other debt without collateral. It’ll beat your credit cards, but not most mortgages, car loans, or business loans. Given some of the ridiculous student loan rates out there, you could possibly beat those too. But you then wouldn’t qualify for deferments, subsidization (going away anyway), IBR, PSLF etc. Plus, the longest term you can get is 5 years, which really doesn’t work for borrowing for medical school.

    But if you have great credit and want a loan in the range of 6-7%, it’s worth a look at. The current best rate you can get is 6.03%. To be honest, I would hope most of my readers wouldn’t need loans for the reason most of these borrowers take them- pay off credit cards, debt consolidation, weddings, cars, start-up businesses, home improvements etc.

  4. Nice article. Your points #4 and #10 are the big reasons I am so bullish on p2p lending. I just wanted to clarify something for your readers. Prosper now uses the same model as Lending Club for setting interest rates. There is no bidding on loans any more that drives down interest rate – they are fixed for both companies.

  5. Thanks for that clarification. I recently opened a Lending Club account and was going to open a Prosper one later this week so I suppose I would have learned eventually!

  6. Thanks for the article on our industry, which is growing rapidly. Any information you need, do not hesitate to ask.

    Once you have invested in notes in both Prosper and Lending Club, (if possible you should do 100 notes on each,) we’ll look forward to you comparing the two; process, returns, etc.

    Glenn G. Millar
    Prosper Employee
    Notes offered by Prospectus http://www.prosper.com/prospectus

  7. Thanks for the reply. That was what I thought, but I was thrown off in #1 when I read “It offers borrowers a chance to get a lower rate than a bank would offer them. I thought I missed something by not hearing of these before.

  8. I’ll chime in on here about my experience with Prosper and why I don’t use Lending Club.

    First, let me say why I don’t use LC. LC’s rates compared to Prosper are for lower as well as the expected rate of return. The size of LC loans are also greater. I like to bid on loans $7,500 and lower and Prosper caters to these needs.

    Now let me talk about Prosper, both the good and bad.

    I’ll start out with the good. I like how they changed to fixed rates. The previous auction process was a joke and benefited the borrower. The new process lets the lender and borrower know what rate can be expected. A loan can also be fulfilled even if it doesn’t fully fund. Here’s a quote from a loan: “Note: this listing will fund at 70% or higher.” Which is great for both the lender and borrower, especially if the borrower needs the money.

    Prosper has revamped their site and now has a nice overview showing your loans, defaults, late loans, overall investment, returns etc. This is a big plus from their previous antiquated website. It is a big improvement and I hope to see more. For example, I know my rate of return from the following years is as follows:
    2006: 9.5% on $500 in loans
    2007: -1.88% on $4,000+ in loans
    2008-2009: I did not invest. The economy was faltering and I expected I would lose money. Prosper was going through a transition phase and I refused to use their website and they were not responding to my concerns and I’m sure other lender concerns. (more on issues later)
    2010: 27.6% on $1,600 in loans
    2011: 23.4% on $1,000 in loans and counting

    Now I only place loans that are listed over 22% and I normally bid on only the highest percent loans. This is obviously before fees, defaults etc.

    Here’s some more stats for you. From almost 100 loans I’ve been a lender on, I’ve had about 20 default. That’s over a 20% default rate. To clarify, the largest percentage of loans defaulted for me in 2007. Since that time the default rate has fallen, even with the loans I’ve invested that are over 22%.

    Ok, so now let me to you the bad about Prosper.

    First, Prosper is extremely slow to make any changes to their site. I’ve complained for years to them and the emails I get back are comical. First, they never address my issue and they don’t seem concerned about feedback from their customers. I believe I have some great ideas, but they don’t seem to really care. Oh well, I’ll continue to try.

    For example, previous you could ask the borrower a question about their loan. Well now you have no interaction with the customer. Why? I don’t know, but it’s frustrating. Previously you could ask a question and the borrower had the option to answer it. If they answered it, they also had the option to post it so other borrowers could see it. Well now you can’t ask the borrower any questions. In my mind, this is a huge step back and it really irks me. Why Prosper?

    Another issue is that Prosper ask the borrower to put why they want the loan and to list their expenses, loans, commitments etc. Well, why this seems like a good idea, it’s all optional. Yep, Prosper does not make it mandatory that the borrower fills in this information. The borrower can simple title their loan with any listing title and leave the rest of their loan blank. All the lender has to go on is the information that Prosper gathers. While this information is good, I ask the lender need interaction with the borrower, I need to know the borrower’s expenses, loans, commitments etc. Prosper, if you are listening, you need to make this information MANDATORY. I’ve seen so many listing with off the well listing titles. These are current examples is listings borrowers have on the site, no joke. “HUSBAND” and the rest of the listing is blank. LOL Come on Prosper is this supposed to be a joke? “MamaCow” and the listing does not explain what the loan is for. “cora”, Here’s a good listing title: “Con”. I kid you not and the rest of the listing is blank, meaning they did not list any information about what this loan is for or about their expenses etc. Here are some other titles, “silvereagle10″, “personal” Hmm, that can be for anything. “TYLINO” turns out it is for home improvement, but they don’t list their expenses. “home work”, I assume that’s to fix their home, but once again Prosper doesn’t make it mandatory that the state what the loan is for or list their expenses! Come on Prosper, this is information that should be mandatory.

    The last major complaint I have is the very high number of loans I invest in that never become loans. I have about 40% of the loans I invest in get cancelled by Prosper. Why? Apparently they didn’t provide the information that Prosper needs before they will allow the loan to go live. Now, here is my issue. Why doesn’t Prosper make the borrowers go through an initial process that allows for a lower cancellation rate? Why is it that I as the lender must spend my time to look over the loans that takes my precious time and to have 40% of them cancelled. This is unacceptable and Prosper has been doing this since 2006 when I began lending. I don’t know what information Prosper but have but they do a very poor job in my opinion by allowing loans to go up for lending, only to be cancelled over and over.

    Sure, I can automate loans so they I don’t have to spend time looking over them, but I enjoy looking at loans and deciding which ones I will or won’t bid on. You don’t have that process with automated lending. This is also why I want the interaction back with the customer and I need the reason for the loan from the lender and what their expenses are.

    Prosper if you are listening fix these issues. It’s not hard but you don’t seem to care.

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