Those of you who have followed the blog for the last year or so know I’ve been “messing around” with a relatively new asset class in my portfolio, peer to peer loans through Lending Club and Prosper. These are fixed income investments, but with a lot more risk (and potential reward) than more traditional fixed income investments. Instead of loaning money to the federal government (treasuries), city and state governments (munis), established businesses (corporates), or to mortgage holders (GNMAs), I’m lending money to individuals. Lending Club and Prosper do nearly all of the work, in exchange for 1% of all the payments the individuals make. Of course, I take on all of the risk.
The loans are completely unsecured, and the individual borrowing the money is really risking nothing more than their credit rating. These are the junkiest of junk bonds. The borrower can use the money for whatever they want, but the most common use seems to be to consolidate their credit cards into one fixed payment. Many of these people claim to be planning to cut up the credit cards after consolidating them, but there’s no way to know for sure. Others state they are borrowing the money for a wedding, a car, a small business, or even home improvements.
I initially started out with Lending Club, and initially made 3 year loans mostly to people that sounded like they would almost surely pay me back. They had high credit ratings and excellent credit histories. Of course, they were only paying me 6-10% to lend them money. Once I did some research on which borrowers actually provide the highest returns using sites like lendstats.com, I realized that even with more defaults, I was likely to be better off lending to people with bad credit, but charging them 20-25% interest on their loans. I recently told my sister about this, and she’s convinced I’m engaged in an immoral practice, enabling people like this. She didn’t seem to understand my counterargument that buying treasuries was enabling Congress whereas I might actually be helping some people get out of debt. The strategies I used with Lending Club and with Prosper were detailed here and here.
At any rate, as money became available in that initial Lending Club account (mostly from the principal and interest I was being paid from these notes) I reinvested it in higher yielding loans. I also opened a small account at Prosper, where I also leaned toward the riskier loans. After 11 months with Lending Club, I am earning an annualized return of 10.5%. After 8 months with Prosper, I have earned 9.4% (annualizes to 15.55%.) I calculate those returns using XIRR, since I don’t quite trust either company to calculate my return. (Lending Club claims I am earning an annualized return of 11.64% and Prosper claims I’m making 8.05%.)
What About Defaults?
I’ve been very fortunate not to have any defaults yet. I’m confident they’ll come, especially as I am now investing almost exclusively in the riskiest loans. I have had a few people make payments late, mostly within the grace period. With Lending Club, I’ve had good success selling these loans on the Folio secondary market, both before and after they make their accounts current, mostly at par value or for a slight loss. By culling people from my portfolio who apparently don’t think it’s very important to pay me in a timely manner, I hope to end up with higher returns in the end. Prosper doesn’t let you sell loans that are currently in Late Status, and I’ve been lucky enough not to want to do so. But at the 20-25% I’m charging these folks to borrow money, I can afford quite a few defaults and still end up with an acceptable return, especially in our current ridiculously low yield environment.
Opened An IRA
Since the interest I’m paid is completely taxable, it doesn’t make sense to invest any significant amount of money with these companies outside of a tax-protected account. In September, I rolled over $5K from my Roth IRA at Vanguard to Lending Club and started making loans. In order to maximize diversity, I’ve decided to only lend $25 to any given person. I’ve had to log in perhaps 20 times for 5 minutes at a time over nearly a month in order to choose 200 loans that met my criteria. There are far more loans available on the platform than there were 10 months ago, making it a lot easier to invest your money more quickly and to be pickier with the notes you choose. I plan to make P2P Lending about 5% of my portfolio, so I’ve got a few more rollovers to go to get there. I plan to get to $10K at Lending Club and $10K at Prosper over the next year in order to eliminate any fees and maximize diversification.
Current Lending Club Strategy
After back-testing the limited data available and torturing it until it confessed, I’ve settled on a strategy that I expect decent returns from. I invest only in 60 month loans, with D to G ratings, no more than $25 to each borrower. I loan only to mortgage holders and only to people consolidating their credit cards (preferably expressing a desire to get out of debt completely) that don’t sound desperate for money. I require a 5 year credit history, at least 5 open credit accounts, and at least 10 total credit accounts. I also require that they’ve been in the same job for at least 2 years. I require a minimum of $3K in income each month, but prefer at least $6K in income. I don’t allow any missed payments in at least the last 6 months, and I don’t lend to anyone who has ever had a public record such as a bankruptcy. I figure if they did it once they might do it again.
This portfolio has an average yield of about 22%. Given our low-return environment, I consider a return of 8% acceptable for the level of risk I’m taking. I figure I can tolerate a default rate of up to 45% of the principal of these loans and still get that return. In order for me to lose money on this investment, the default rate will have to be higher than 63%. Considering I have no defaults in nearly a year, this is looking pretty good so far. Obviously a default in year 5 will hurt my return a lot less than one in year 1 of the note.
If you’d like to dip your toe in and check out peer to peer lending for yourself, please use the links below to open an account. It doesn’t cost you anything and it helps support the website.