Peer to Peer Lending Update

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.

Risky Investment

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.

Initial Strategy

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.

Solid Returns

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?

invest, investor, investing, lending

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.

Lending Club Investing Account
Lending Club No Fee IRA
Prosper Investing Account

Enter Your Mail Address

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Comments

Peer to Peer Lending Update — 25 Comments

  1. I’m sorry to say that I have to agree with your sister. You have a great website and a great desire to help people (both in medicine and in finance). Don’t turn your back on those who need a loan (even if it is only $25) and charge them “credit card like” rates of interest that you yourself would never accept or advocate. You state that you will only extend loans for people that “don’t sound desperate for money”. You have too good of a website to think that people who are willing to pay 20+% in interest are not either desperate for money or lacking in financial acumen (again, even if the loan is only for $25). You don’t want the financial world taking advantage of physicians. Please don’t casually slide into taking advantage of people taking these loans because it provides you an opportunity to boost your returns….I can see how it’s tempting, and how it’s legal and fair, but it’s just not good karma. You can do better. Keep up the good work. I enjoy you posts.

  2. I agree with Mark and your sister but for different reason. I believe like lot of p2p lenders, greed is taking hold of your p2p lending. I will say the same to you what I tell any investor who starts chasing returns after entering and having some success in an investment/asset class … Think back about the reasons when you first started out in an investment and asset class. Are you still in the investment for same reasons? have they met your expectations? isn’t that enough? … If reasons change, what caused this change? Are they valid reasons or result of behavioral influence due to past performance, personal experience, overconfidence in your own ability? Unless the cause for change is external, any internal reason is nothing but greed.

  3. i dont think he is really preying on these people. these folks come to peer to peer bc they dont have a cheaper or better option.

    im just not certain one can really recommend the strategy as something that is dependable.

  4. It is an interesting question and one I have pondered myself. Is lending money to someone at 24% doing more hard than good? What I did, through my blog, is reach out to several borrowers to find out. All of borrowers I spoke with were very grateful to receive the money and were happy to pay that rate because the rates they paid on their credit cards were over 30%. These people often mentioned they also liked the forced discipline of a fixed monthly payment and a fixed loan term so they knew their debt would be paid off.

    If they hadn’t got this loan most of them would still be struggling with their credit card debt. So, I would argue, despite the high interest rate, as investors we are doing these borrowers a favor. Of course, we don’t know if these people will get back into debt in the future but we have at least provided them with the opportunity to get out of the debilitating credit card debt cycle.

  5. Mark and April-

    A few comments. Remember these people aren’t borrowing $25. They’re borrowing $5-35K. They’re just only getting $25 of it from me.

    Also, I’m not doing P2P Lending to help people out. I understand that some people get into P2P for that reason. I’m not one of them. I’m in it for the return. Just as I don’t loan money to the government so they can fight AIDS in Africa, destroy the Taliban, and keep National Parks open, nor buy a portion of ExxonMobil or Apple out of the goodness of my heart. I’m doing it to grow my retirement stash. So to be quite honest, I really don’t mind if some idiot wants to take out a loan at 20%, so long as he pays me back, at least most of the time. Just like I didn’t care if some fool wanted to sell me his shares of Vanguard Total Stock Market Fund back in March 2009. I admit it’s very different from my motivation for both my practice and this site (although I make money from both of those as well). You notice I don’t regularly recommend that readers actually take out a loan through these organizations. In fact, I don’t recommend consumer borrowing at all. Some investors try to only invest in a socially responsible way. That is unfortunately a recipe for poor returns, not to mention one man’s “socially responsible company” is another man’s evil-doer. Think about a company like Chick-Fil-A for example. I do think 18-24% is a reasonable rate for the risk I’m taking on. These are completely unsecured loans, and defaults are expected to be high. If I were loaning money to these folks at 8%, I’d probably have a negative return. I avoid those who sound desperate only because I think they’re more likely to default.

    That said, I agree with Peter that I am doing these folks a service. As near as I can tell, most of the people I’m loaning money to for 18-24% are currently paying 30% interest (at least on some of their cards) and missing payments occasionally resulting in additional fees. They also aren’t paying their loans down very quickly because they’re making minimum payments. Plus, I’m helping them simplify their life (and avoid fees) by giving them one payment a month instead of a dozen. If I help them get out of debt in 5 years instead of 20, that’s a good thing. Yes, I suppose some might go right back out and charge up their cards, but you know as well as I do that the bad habits of some people can’t be fixed.

    The reason I went from loaning money for 3 years to people worthy of an A grade loan to loaning money for 5 years to people who are only worthy of D to G grade loans was because the data showed it was likely to result in a higher return by a few percentage points. Higher risk= higher expected return. If you want to call that greed, that’s okay, but it’s the same reason I invest in index funds instead of actively managed ones and have dedicated portions of my portfolio to microcap and emerging market stocks. I do not expect returns of 20%. I do, however, expect returns of 8-12%. I suppose one could consider that I’m REALLY helping out those few people that decide to default on their loans.

    @ Rex- I’m also not 100% certain this is a dependable strategy to make money. But it appears to be quite promising and certainly worthy of 1/20th of my portfolio. Lots of people have far more than that in Apple or their own company. I’ll report on my experience as I go and you can decide for yourself. I may be eating humble pie two years from now. I do recommend if you want to try that you start small until you decide if it’s really something you want to commit money to.

  6. I don’t think there is anything wrong in doing this. It is not like you have a gun to these people’s heads. In fact, you are helping them out. You are lending them capitol and they are taking the capitol to better their lives. If there was no way for you to borrow money, you probably would have not gone to medical school if you had to shell out a check for $50k/ year.

  7. I have no arguments on moral grounds at all – whenever you buy any stock, you are buying it with a goal of making a profit, and someone is selling it with the same goals.

    My only contention is that in a month, you log on 20 times for 5 minutes at a time. That’s approximately 120 minutes (2 hours) a month. At your average hourly rate of 200/hr, you’re looking at nearly 400 dollars of lost revenue (if you worked just 2 extra hours a month).

    Now you’ve got 10k invested with an expected 8 percent yearly gain is around 800 dollars, far less than the 4800 you’d have over a year (that can then just be funneled into an index fund at 4-6%). Not to mention less stress and it’s something that you’d already love doing. If it’s 5-10 percent of your entire portfolio I just dont see it being worth the time commitment.

    I love you blog and pass it along to all my friends, thanks for doing what you do.

  8. Sorry my initial math was wrong, I’m reading post-overnight but you get the general principle. I didnt have a calculator handy and should have proofread.

  9. As a fellow p2p lending enthusiast, I would direct your sister and those in her camp to the loan listings where the borrowers answer questions about their current debt situation. Often times these borrowers have $20k of credit card debt or more at interest rates of 22-29% that make minimum monthly payments in excess of $1,000. Keep in mind that making these minimum payments do not make much of a dent in the principal of their balances. Giving these people fixed-rate, fixed-term loans of 3 or 5 years can save borrowers hundreds of dollars each month and the comfort of knowing that after 36 or 60 months or sooner that they are debt-free.

    Also important to consider that p2p lending fills a niche that our inefficient banking system is unable to address currently. I fully expect p2p lending to become a more common sight in the portfolios of retail investors over the next decade.

  10. Lending club has issued millions upon millions of dollars in loans. However, they are still not profitable as a company. Does it make you nervous to invest your money with a company that has yet to turn a profit? I’m concerned that one day they may simply be unable to stay afloat – and there goes the money! Thanks for the blog – keep up the good work.

  11. Jason, I have spent a great deal of time studying Lending Club in the last two years and while it is true they have never made a profit they are in a very strong financial position. From their latest SEC filing they have over $50 million in cash on their balance sheet enough to keep them afloat for 5 years assuming no growth. But we know they are growing dramatically so their financial position will be even stronger when their next filing is made public.

    Here is the bottom line. Lending Club will certainly turn a profit next year and unless something dramatic happens they will continue to grow and take market share away from banks. While the money you are investing is not FDIC insured Lending Club is becoming a lower risk investment all the time.

  12. Neil- You’re absolutely right that P2P Lending is far more time consuming than just buying a handful of index funds. There are ways to decrease the time, but if you want to manage 800 loans, well, you’ve to manage 800 loans. There are some funds where you can pay someone else to do it. You know where the money to pay them comes from. I expect to see more of a public mutual fund available within a few years, and am likely to use it if the costs are acceptable.

    Jason- There is a plan in place in the event that Lending Club goes belly up. The money isn’t in Lending Club’s coffers, just like your money in a mutual fund doesn’t disappear if the fund closes.

    Peter- While LC may be becoming lower risk, it’ll never be a low risk investment. The underlying investments are by their definition, quite risky. In a severe economic turndown, defaults could rapidly rise to quite substantial levels, taking your earnings and principal with them.

  13. A good way to quantify if your loans are doing good or not, is to look at the credit score Trend of your borrowers. Most of my loans are for debt consolidation as well, and through the loan descriptions we see that most are paying off multiple credit cards to get a lower rate, fixed term loan to get out of debt. I have been tracking the credit trend in my portfolio for a few months now, and consistently see ~70% with an UP trend, versus ~20% with a DOWN trend, and ~10% FLAT.

    I’m not in this for the charity either, but I definitely think these loans do more “good” than not.

  14. White Coat Investor…………..Your performance update would be far more illuminating if you were to include information such as the number of notes in your portfolio, balance between 3 yr & 5 yr. loans, average age of notes etc. Considering how detailed your update is, I’m a bit surprised that this information is missing…………..without which a reader can’t really determine how you’re doing, nor any way to compare your results to others who report theirs on a regular basis.

    Here is my oldest LC account. I use my own set of filters, invest daily & pick all notes individually.
    Opened Oct 2009
    Number of notes……………1650+
    Avg. age of notes…………..1.5 years
    Balance……..84% 3 year notes, 16% 5 year notes
    LC calculated NAR return number………13.5%
    XIRR ROI number…………….15.2%

    Peter……….I see no evidence that Lending Club is taking “market share away from banks”. Is this your guesstimate/projection or is this fact?

  15. Dan, Always good to hear your thoughts. And no I don’t have any empirical data to suggest that LC has taken market share away from banks. It was merely an observation that in the early-mid 2000’s many people were doing debt consolidation loans with their HELOC’s and these loans were often originated through a bank. Today that market has all but disappeared. I don’t have any hard data to support those last statements either but have formed that opinion after reading many articles on the subject over the years.

  16. Dan-

    That’s a good idea. Most of my performance data comes from my initial foray into them a year ago, where I put in $1000 to LC (40 loans) and $500 into Prosper (20 loans). In the last month I’ve put another $5K into LC (200 loans) and have another $5K headed there now. All the Prosper loans are 3 year loans, and all of the original 40 loans at LC were 3 year loans, but every time I replace one or buy another one I get a 5 year loan. All the new ones are 5 year loans. Since 80%+ of my loans are now brand new, the average age of my loans is quite low now.

    I’ve replaced a handful of notes as they either made a late payment or several in the grace period, but don’t have any defaults yet in those original 60.

  17. For those wondering about these borrowers and their motivations, here’s a typical example I invested in today. This loan has a yield of 23.83%.

    Gross Income: $11,667 / month
    Current Employer: Xerox Consultant Company, Inc
    Home Ownership: MORTGAGE
    Location: Linn Valley, KS
    Length of Employment: 2 years
    Debt-to-Income (DTI): 22.94%

    (as reported on credit bureau on 10/15/12)

    Borrower Credit History

    Credit Score Range: 665-669
    Accounts Now Delinquent: 0
    Earliest Credit Line: 03/1996
    Delinquent Amount: $0.00
    Open Credit Lines: 20
    Delinquencies (last 2 yrs): 0
    Total Credit Lines: 34
    Months Since Last Delinquency: 24
    Revolving Credit Balance: $17,035.00
    Public Records on File: 0
    Revolving Line Utilization: 83.10%
    Months Since Last Record: n/a
    Inquiries in Last 6 Months: 3

    (not verified)Loan Description
    Borrower added on 10/17/12 > Would like to consolidate debt and eventually pay it off totally.

    Borrower added on 10/18/12 > we focused in the past couple of years on a medical issue and household items which were necessary. We now want to consolidate down to one payment each month with an end in sight for being out of debt completely.

    Q: What are your current debt balances, interest rates, and monthly payments by type (credit cards, student loans, mortgages, lines of credit, etc)?
    A: (10/18/2012-09:13) – Most of my current debt is credit cards or small loans ranging from 11.98% to 26.99%. I have no student loans, two car payments and one mortgage. I would like to roll all the small loans and credit cards into one payment so that I can have a fixed payment of it all where I see that in 5 years all my current debt is resolved.
    Q: What are your current monthly expenses (rent, transportation, utilities, phone, insurance, food, etc)?
    A: (10/20/2012-06:09) – mortgage 785 car1 615 car2 711 elec 385 water 120 dish 126 phone 125 cell 145 insur 160

  18. White Coat…………To each his own, of course………………but I would have never invested in that loan. Why? For starters, I don’t like the fact that his last delinquency was only 2 yrs. ago. The 2nd red flag for me would be his 3 credit inquiries within the last 6 months. That, in my opinion, is way excessive. And if those 2 issues weren’t enough, & although I rarely read loan descriptions, just the hint of the word “medical” anywhere in the loan app. should make any smart lender nervous. This loan would have failed 3 of my filters. I wouldn’t have cared how much this person makes or the fact that the interest rate is rather attractive.

    Good luck with this one. :)

  19. Medical issues make me nervous at times too. It is a leading cause of bankruptcies. Maybe I should have skipped this one for that reason. I’ve scoured the data, and as near as I can tell the only time delinquencies hurt returns is if they’re in the last 6 months. I haven’t noticed a trend that credit inquiries hurt returns. Heck I’ve probably got 3 inquiries in the last 6 months. Who doesn’t with all the refinancing going on these days?

    I think it’s important that you base your decisions on data. There are a lot of things that I would think would affect returns, that apparently don’t, or else those factors are already factored in to the formula (for example inquiries affect your credit score so they’re “baked in”.)

  20. White Coat…………..If you in fact base your decisions on “data” you’d have discovered that the biggest determining factor on returns at LC is “inquiries”. The more inquiries on average, the higher the default rate, therefore the lower your return. Setting your filter at zero inquiries is in fact the best thing that an investor can do to minimize defaults.

    You don’t know me, but I encourage you to check around with others as to whether I know what I’m talking about. I have a 3 year record of 15% returns at LC. I welcome any wager you’d care to propose that has you equaling or bettering my results within that time frame. What do you say?

  21. Thanks for the tip Dan. I’m not actually into “competitive investing.” My goal isn’t necessarily to beat anyone else, but simply to meet my own investing goals. I’ll look into the inquiries as I apparently overlooked that option while pouring over the data prior to investing.

    Continuing to compound returns at 15% will make you very wealthy in a short period of time. Nice work. I do P2P as a much less efficient market than most of the markets I invest in. Additional work and knowledge can increase returns substantially and you seem to be demonstrating.

  22. Dan-

    I stopped by lendstats.com today to look into the inquiries thing. For the period Jan 2009 to present, F loans with 5-10 inquiries had returns of 19.5% E loans had returns of 13.5%. If you look at the same period for 1-5 inquiries, you see returns of 8.2% for E, 8.9% for F, and 9.8% for G. For 0 inquiries, you see 9.7% for E, 9% for F, and 9.6% for G.

    That seems awfully counter to your argument above. At my first glance, more inquiries seems to lead to HIGHER returns. Certainly there’s no significant difference between 0 and the 3 noted in the loan above. What data are you looking at to support your hypothesis that more inquiries leads to lower returns?

  23. If you’re in it for charity – try kiva.org (a good organization)

    That said, charitable investing and investing for return are two different animals.

    (i happen to do both)

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