In 2006, I took out a Prosper personal loan to consolidate some credit card debt and it ended up being an important step in my achievement of paying off $80,000 of debt in a little over three years.
When I emerged from debt, suddenly I had this money I had been putting to monthly debt payments available to invest. So I padded my emergency fund, maxed out a Roth IRA and began looking for other ways to diversify my investments.
As an experiment, I began making small investments in loans to other people through Lending Club. Obviously, I was pretty high on the idea and — full disclosure — I became an affiliate of both sites (meaning this site may earn a commission for referring new customers). Today, however, I wanted to provide an update of what it’s been like as a Lending Club investor for three years. I’m not singing praises to try to get you to sign up (although if you want to, you know, hey, thanks!). Rather, I hope this will be a candid look at the pros and cons to investing in other people’s debt.
What is Peer-to-peer Lending?
If you’re unfamiliar with peer-to-peer lending, it’s a way for regular people to loan other regular people money without a bank.
Let’s say you want a $1,000 loan. I invest $25 to lend you (along with 39 other people). We keep our individual investments small in case you default on the loan.
We agree on an interest rate and a term, and you begin paying back the loan. The peer-to-peer network (e.g. Lending Club) disburses the money and collects your payment each month. They take a fee for originating the loan. Then, they take the interest you’re paying on your loan each month and pay it to me and the other investors.
Peer-to-peer lending got a lot of play during the credit crisis because so many banks stopped lending, even to creditworthy borrowers. Companies like LendingClub picked up some of that slack and had some very good years.
My Lending Club Investments
I invested a total of $5,225 in Lending Club over a period of a year, beginning about three years ago. Today my account is worth $6,182.11, reflecting a net annualized gain of 6.62 percent. I’ve received $1,719.69 in interest, but I’ve also paid service fees and lost money from uncollectable loans.
An annual return of 6.62 percent isn’t bad, especially when savings accounts are paying less than 1 percent. But 6.62 percent is a bit on the low side considering the risk involved in lending out my money.
Lending Club provides statistics based on the overall performance of the more than $2.6 billion in funded loans they’ve processed. As you can see, investor performance varies widely. Invest with Lending Club, and you could earn more than 15 percent return, or you could lose money.
Most investors, obviously, fall in the middle where I am – earning a NAR of between 6 and 9 percent. The above chart shows how diversifying your investment over at least 200 individual loans (a $5,000 minimum investment at $25 per loan) minimizes your risk.
Three years ago, I remember the average return statistics looking a little rosier, and I optimistically expected to earn a NAR of something like 10 or 11 percent. But over time, some loans don’t perform. Ask any banker. If you are in the business of lending money, the difference between making millions and going bust is whether people pay you back, pure and simple.
Successful Lending Club Investing Takes Work
With Lending Club, you get to choose which loans you invest in. If you’re lazy, you can choose from automatically generated portfolios like those shown here.
But savvy investors create their own portfolios based on much more conservative criteria than Lending Club uses to approve loan listings in the first place. For example, you might choose only to loan money to borrowers who have verified their income or to borrowers using the money for business reasons instead of debt consolidation.
Because the other problem is, people lie. Lending Club can verify some information like credit information, but lots of the information on the loan application is simply submitted by the applicant, making it dubious at best. Still, screening is important because you come across loan apps with red flags that you can rule out.Trouble is, if you plan to diversify your investment over hundreds of loans, it’s unlikely you’re going to vet everybody to whom you lend money as thoroughly as you’d like. In the beginning I started by hand-picking loans based on why people were using the loan and their employment history. But even that’s not perfect.
An even then, you certainly cannot predict whether a loan will default.
Lending Club grades loans based on risk A-G. The higher the grade, the lower the risk and the lower the borrower’s interest rate. An A loan has an average interest rate of 5.47 percent, a G loan has an average interest rate of 23.8 percent – eek!
But the thing is, I’ve had as many A and B loans default as Es, Fs, and Gs. Banks spend millions of dollars on entire departments of people to predict who will pay them back and who won’t. Without that luxury, the best strategy a Lending Club investor has is diversification: Keep your investments small and diversify across loan type, interest rate, credit rating, even geography.
Finally, there’s no automatic reinvestments with Lending Club. Each month I receive principal and interest payments as cash in my account. If I do nothing with that money it sits there as cash and ceases to earn a return. Lending Club sends me emails periodically to remind me I have $X sitting idle, but I have to manually go in and find new loans in which to invest.
Even if Lending Club were to offer an automatic reinvestment option, it wouldn’t be ideal because, after all, we want to screen the loans we’re choosing!
It’s Getting Harder to Invest in Lending Club
So far I’ve presented a the big pros and cons to peer-to-peer investing: It’s a fun alternative to the stock market that so far yields a decent return. On the downside, it’s a bit risky and requires frequent diligence to vet loans and invest wisely.
The final stumbling block I see with peer-to-peer lending is that it’s becoming more competitive to invest in the “good loans”. As Lending Club has proven itself, professional investors with millions of dollars are lining up next to the hobbyists like me with a few thousand. And you can bet these institutional investors are using algorithms and analysts to find the best loans.
As a result, the least risky loans tend to get funded very quickly so investors who don’t spend a lot of time watching loans end up with riskier investments. I hope that small-fry investors can continue to enjoy and profit from Lending Club for years to come, because what made the platform cool was the fact that average Joes could lend other average Joes money without the meddling of a bank.
What about you? Are you an investor in Lending Club, Prosper, or another peer-to-peer lending network? How have you done?