Peer-to-Peer Lending
If you thought that buying stocks, bonds and real estate were the only way to invest you left out Peer-to-Peer lending. Many people are unaware of this platform since it is not offered by employer 401k plans or brokerages.
The idea behind Peer-to-Peer lending is that someone needs to borrow money and you have money you want to invest. Simple right? You do not know the person who is in need of a loan and that person does not know you. There is a party that knows both of you and they put the deal together.
The Lending Club
One such company is The Lending Club. I became familiar with them about three years ago after reading an article published by a national authority. I have always been interested in alternatives and after investigating the concept decided to take a leap and invest.
Your first step is to go online and sign up at the Lending Club website. It’s an easy process. You can send a one time electronic funds transfer or you can set up a recurring transfer e.g. every two weeks when you get paid.
Once the funds are in the account and it is fully activated, you will have choices for investing your money. Each loan is a fixed amount of $25. The purpose of this is to permit people to diversify their investment. Before I go any further you need to know that not every loan goes to term meaning that some people pay off their loans early.
Also, a percentage of borrowers default on their loans. This is hard for for most people to deal with. When you loan money to a friend you usually get the money back. This is different, now you are the bank. You know how some people feel about banks. “I cannot afford to pay the bank back, that big corporation is trying to sue me for not paying them, how can they do that?”
As a lender, you see the ugly underbelly of the lending business and the reason why credit card companies charge such high interest. So many people default on their loans that the losses are pushed out to all credit card holders in the form of higher interest.
The way this is done with Peer-to-Peer is that you have so many loans that the loss of one or more is not so painful because the platform explains that while the average interest rate contracted for throughout all of your loans is for example 15%, the actual you will earn may be 5%.
It’s the 5% or 6% or whatever you are looking to net that is important. Regardless, it’s aggravating to see a person obtain a new loan for $30k and not pay a penny. You get to see all of the collection activity which goes into pages. Attempts to contact with no reply. Outright fraud in my opinion.
Now that we have that out of the way, time to get to the mechanics of the process.
You can either select an automated investment program which you can customize or you can select individual loans. Most people use the automated approach because they do not have time to visit the site every day to invest. If you choose automated you can still go in anytime and invest any free cash.
Loans are set up in categories e.g. A, B, C, D, E. There are grades within each numbered A1, A2 etc. The interest rate rises as you go down the alphabet with A1 being the lowest rate charged to anyone on the platform.
You will be presented with some blended choices for automation unless you want to set your own. For example a choice may be 25% A, 30% B, 35% C and 10% D. Which means that the blended interest rate will be fairly high in double digits. This is of course the contracted rate. Defaults will affect the rate. On an annual basis, you net rate will depend upon how fast money is invested, expenses and defaults.
The program is not free
This program is not free. The Lending Club takes 1% for fees off the top so when your effective interest rate is displayed (they call it NAR), it is short that 1% but other items as discussed above.
Collection fees are assessed against your account but that comes from the funds collected from loans that were in default and charged off. Both collection fees and the income from collections is shown on your statement.
The entire process is easy and it’s a set and forget much like leaving funds in a bank savings account. You can get as involved as you want to the point that you do research on every loan and make decisions. The platform provides all but the name of the person requesting the loan so you can make informed decisions.
Prospective borrowers information provided includes credit score, income, source, homeowner or renter, amount owed, previous credit history, purpose and amount of the loan and other key points.
You could for example decide to loan only to A borrowers. If you do this your net return will be low for example 4%. If you loan to a blend of A and B, your expected net will rise to for example 6%. Various blends will change the expected net. Their system uses data from the billions of dollars of loans they have managed since 2006 so the expected return will be in the ballpark.
You decide upfront if you want all loans to be 3 years or 5 years. There are strategies for terms that you can consider but I will not get into that here.
In my opinion and others have theirs, the return from Peer-to-Peer lending will not equal high dividend investments in for example REIT’s or real estate. It’s possible that the stock market in a given year will far exceed the best that this platform can do.
Little to no volatility
But and this is a big but, there is little to no volatility. The idea is the law of large numbers. If for example you invested $5,000, you would have invested in 200 loans. If one goes bad, 199 will support this with no issues. If a few more go bad the net will be affected but keep in mind that you start with something near 10% or more then after calculating defaults averages say 5%, well you hit your target.
My idea is that The Lending Club is competition with money market funds which are yielding so little as to be laughable even after the FED has increased interest rates. You can go in every month and after about one year the net rate will settle down to something that changes by perhaps one tenth of a point from month to month.
Do not be shocked to see a high interest rate right out of the gate in month two. This is because the way interest is calculated, the first months payments contain the highest amount of interest. A good example is a loan for $25,000 over a three year period. The interest portion of the first months payment at 8% is $166.67. The second month the interest portion is $162.56.
If all 200 loans were issued the same date, your income would diminish over the two years on a monthly basis as loans are paid down. A good thing is that people often pay their loans off within a few months or early in the three year period and those funds recycled into ln new loans with higher immediate yields.
If it were not for the defaults, this platform would exceed anything else available since some of the D loans for example have interest rates above 20%.
Your standard account will generate income which is taxable. At the end of the year the Lending Club will issue IRS forms that you use to calculate the income that you owe taxes on.
Roth IRA option
A Roth IRA option is offered through a third party that works with your Lending Club account. If you deposit $10,000 or more the Lending Club will pay the fees. If you put in less than $10,000 after the first year you will be assessed fees by the IRA provider. Please check with the Lending Club to verify this information as this information may be out of date.
You can earn referral income by sending friends to the platform.
At anytime you can request the Lending Club to send any available funds to your bank account. Payments are made by borrowers all month so funds can be available at any time in your Lending Club account. The idea is of course for the principal and interest coming from borrowers to be reinvested for more growth.
If you are retired for example, you can withdraw the interest and let the principal ride. You can deposit any amount at any time in the regular account. The Roth IRA is subject to the IRS maximum per year.
At some point if you are in need of cash and want to withdraw from your Lending Club account, you can sell some or all of your notes on their trading platform. Anyone buying them will want to buy at a discount so this is not something you do on a regular basis.
Now for my personal experience and I have not been paid to write this article
My rate of return has been around 3%. I was using the automated system for some time and my initial rate of return was over 10%. I used the recommended blend program. At the time, they had higher risk categories that have since been discontinued. So, some of my loans went to people with lower credit scores. The Lending Club increased it’s lending rates and it’s minimum credit scores but that was after many of my higher risk loans had defaulted.
As the Federal Reserve Bank raises it’s interest rates, Peer-to-Peer platforms will follow. This will of course not affect the fixed rate loans that are already in your portfolio but every day when fresh cash arrives and is invested at higher interest rates, your return should continue to grow.
I decided to change to all A loans about one year ago so that lowered my expected return. At this point, about 70% of my loans are A loans but I still have some high risk loans. The default rate has slowed at the same time those loans that I started with three years ago are coming close to maturity so the interest portion of the payment is low.
With in a year I expect my average to increase as the original loans are paid off and almost all of my loans are A loans earning greater than 7% return.
Even A loans default but the percentage is far lower than any other category. My risk is reduced but so is my return. At some point, I will introduce some higher risk loans and improve my return. As the economy continues to stabilize in the upward direction, defaults should slow. Without doubt some applicants have lost their jobs and this has caused defaults.
Peer-to-Peer platforms will continue to grow
I believe that as the Peer-to-Peer platforms grow with more experience, the default rate will slow. A while ago it was possible for criminals to obtain loans from more than one Peer-to-Peer platform within a week or so. The systems are more intelligent now and should catch that.
Investing in a Peer-to-Peer program like Lending Club is a method to diversify your investments, not the only place to invest. If you have money in equities and real estate, try the Lending Club as a third leg of your portfolio.
