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.
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.
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.