Long term readers will recall that I branched into a new asset class a few years ago, Peer to Peer Loans. I saw a chance for high returns coupled with low correlation with the rest of my portfolio, exactly what you want from any given asset class in your portfolio. So in November 2011, I started dabbling in it to see how it worked. 10 months later I was ready to commit more serious money. Despite the promise, given the short track record and unique risks, I elected to only put 5% of my portfolio into this asset class. 4 years later, things are going great. I write this post as an introduction to the asset class for those who have never heard of it, as well as an update for long-term readers to let them know how it has worked out for me. I'll briefly list the upsides and downsides of this asset class:
Advantages of Peer to Peer Lending
- High returns
- Low correlation to the rest of my portfolio
- An opportunity for active management in an inefficient asset class
As mentioned above, the main benefit is the promise of double digit returns at a time when many experts think stocks may only return 3-7% going forward and bonds may only return 1-3%. $10K invested at 10% for 30 years equals $1.6M. At 4%, that only grows to $560K. High returns are worth a lot sometimes. But both in theory and in practice, correlations with stocks, bonds, and real estate have been very low. Students of modern portfolio theory know that the combination of high returns and low correlation is the holy grail of asset classes. In addition, there is the possibility of further boosting your returns through active management. Like real estate but unlikely publicly traded stocks and bonds, P2PL is still an inefficient asset class, and a skilled manager can add value.
Disadvantages of Peer to Peer Lending
- Single party risk
- Short track record (but getting longer all the time)
- Higher expenses than index funds
- Lower liquidity
- Hassle factor – Security selection, active management, and tax preparation
- Tax-inefficient
The main downside is the single party risk. While Lending Club, Prosper, and other big players have plans for what will happen if things don't work out and their company goes bankrupt, chances are good that most investors will take a pretty good hit on their investment if these companies go out of business. Other downsides include the short track record, expenses of around 1% (perhaps more if you're paying someone else to manage your notes), less liquidity than publicly traded stocks and bonds, and tax-inefficiency. Another serious downside of this asset class is the hassle factor. Picking thousands of notes is a pain, and deciding when and how to sell them is also a big hassle. And if you're doing this in a taxable account, prepare for a major hassle at tax time.
How Peer to Peer Lending Works
Basically, you go to the website of a company such as Lending Club or Prosper and open an account, either a taxable account, an IRA, or a Roth IRA. You then select notes to invest in. Notes are loans to individuals who want the money to refinance their credit cards, start a business, pay for a wedding etc. These folks pay interest rates of 6-24%, the company takes their cut (typically 1% of every payment), and you get the rest. If they default on the loan (which happens frequently), you lose out on whatever they didn't pay back. It is important to realize that the yield is not your return. Your return will be much less than the yield due to the defaults. The key is to have a relatively low default percentage for the interest rate you are receiving. For example, if you bought a bunch of notes with a yield of 20%, held them for five years, and had 20% of them default immediately, you would still end up with a return of 15% per year on your original investment. In fact, you would still break even with an immediate default rate of 60%!
My Strategy on Peer to Peer Lending
Once I was convinced of the merits, I opened a Roth IRA at Lending Club and every few months transfer a few thousand from my Vanguard Roth IRA to a self-directed IRA invested in Lending Club notes. I use an automated investing service called Interest Radar (not a paid advertiser, but they have waived my fees for a couple of years) to do the actual investing. My basic strategy is to invest in D-G debt consolidation loans only, with 0-1 inquiries and a credit score under 714. I also required a credit card balance over $10K, credit utilization > 50%, and a monthly income of at least $6000. I haven't changed this criteria in at least a couple of years. Yes, I agree the people I am loaning to aren't very smart. They've got a $72K+ income and hold more than $10K in credit card debt they're willing to refinance at 16-22%. But it seems to be a good strategy and hopefully some of them are actually getting out of debt at some point (although I can't imagine how while they're paying 20% interest- I thought 6.8% was bad.) Initially I was selling loans that were late, but I haven't done that in a year or two. It was a lot of hassle, and I wasn't sure I was coming out ahead doing it. At the price I could sell them for, it was worth just waiting to see if they started paying again.
Peer to Peer Lending Returns
So what kind of returns am I seeing? I use XIRR to calculate my returns. I have three total accounts, a small taxable one with Lending Club, a small taxable one with Prosper, and the larger Roth IRA with Lending Club.
My Lending Club returns have been: 3.22% for 2011 (just 2 months), 13.69% for 2012, 13.27% for 2013, 11.48% for 2014, and 7.87% through the first 10 months of 2015. My Prosper returns have been 4.48% for 2012, 10.64% for 2013, 4.61% for 2014, and 7.09% for the first ten months of 2015. All together, my annualized return over the last four years is 11.25%. As a general rule, you expect your returns to fall over the years due to defaults as your loan portfolio becomes more mature. My goal was 8-12% returns, and I'm clearly still well into that range.
Ignoring the two smaller accounts, I have purchased 1493 notes. 299 (20%) have been completely paid off. 1044 (74%) are current. 21 are in the grace period. 3 are 16-30 days late, 39 are 31-120 days late, and 79 (6%) are considered defaulted/charged off. I haven't transferred money into the account since May 2015 and 80% of the funds have been in the account for at least a year and a half, so it's a pretty mature population of loans. 50% of the loans are D, 33% E, 12% F, and 5% G and they're nearly all 5 year loans, so the average interest rate is 19.6%.
Remember that with an interest rate of 20%, I can see an immediate default rate of 20-40% or more and still see great returns. My default rate is lower (hard to tell how much since I used to sell late loans) than that and so even with the fees I'm getting pretty good returns.
Want to Play?
If you’d like to get in on Peer to Peer Investing, I would appreciate it if you would use the links on this page to open your accounts. This website gets a small amount of money (and it doesn't cost you any more) if you open an account through these links.
Lending Club
Prosper
Please be sure to limit your investment in this risky asset class. It might be fixed income, but these aren’t treasuries and there are some very unique risks in play here. But as you can see, potentially good returns are available and the faster your money grows, the sooner you reach your goals.
What do you think? Do you invest in P2PLs? Why or why not? What has your experience been like? How have you automated your investing? Comment below!
Featured Real Estate Partners
Very interesting…I think it makes a good use of 5 percent of your portfolio.
Two questions:
1. How does InterestRadar work with LendingClub or Prosper and how hard is it to set up?
2. What are your thoughts on SoFi, Upstart and other peer lending sites? I saw you did a post on SoFi from the perspective of the borrower, but what about from the lender’s view?
https://www.whitecoatinvestor.com/sofi-and-the-rheumatologists/
It’s easy to set up. There is a fee but basically it allows you to automate the whole process, which is key to me. I simply don’t want to log in every few days to buy notes (which is what I was doing originally- definitely not worth that.)
I haven’t used any other P2PL sites. I don’t think the returns at SoFi were particularly attractive last I looked at it.
The tax hassle has kept us out along with the fact that it feels unethical to my wife.
By the way, the link to Prosper yields this: OOPS! Your offer could not be found…
I don’t know, the links are working for me.
Both links work for me now as well.
Do you know what happened to P2PLs in 2008? My guess is that they would have really tanked (through default), and that they would not have reversed as the market did in 2009 and beyond.
“Prosper 1.0” was going on during 2008 and returns weren’t great. There is a lot of debate as to whether the issues that caused that were fixed with Prosper 2.0 or whether it is a result of the recession.
P2P might have a low correlation with other asset classes now, but it will be highly correlated the next time there’s a recession. Right now P2P is riding the wave of economic recovery, and we’re theoretically at full employment. When the employment rate drops, watch out. Most of those loans will default.
Maybe you’re right, maybe you’re not. I don’t really think there is enough data to say.
Tax hassle has kept me out. Agree that its probably something you should scale into safer notes if a recession gets started, all correlations got to 1 as they say.
Definitely interesting though, especially the automated aspect. I like your criteria of choosing people that are basically gainfully employed but just not making smart moves financially, that was a lot of us before the site.
Thanks for the info.
Do you have idea what happens to the borrower if they simply decide not to pay back? Eg, is there a collection process? does it affect their credit score and make an entry into their credit report? I guess my question is, what’s stopping a borrower from just defaulting after taking a P2P loan.
Thanks,
Yes, they send it to collections and their credit is ruined. But that’s about it. Really no different than the people who come to an ED and never pay their bills. There’s no debtors prison any more and these notes aren’t back by hard assets like a house or car.
I would be scared, when a recession hits, unemployment goes high that there would be a lot more defaults. If the return comes down to the market, it becomes an uncompensated risk.
Plus it does need to be actively managed. My whole idea was not to chase higher returns because every ones crystal ball is cloudy. Every month I hear about some one beating S/P for last 30 years with a strategy that has been back tested and will not fail. At least this one is not back tested.
Even among bogleheads you will see people adding healthcare, biotech, small value, REITS since they say these are recession proof (OK maybe not small value) or low correlation.
I just find it a little skeptical
If you’re scared, you certainly shouldn’t invest in the asset class. It certainly isn’t mandatory.
My personal experience from 2014 through the middle of 2015 with Prosper was not great. I had a fairly well diversified portfolio of loans and kept getting defaulted on. I found no correlation between the credit level of the loan and whether or not I would get defaulted on. I closed my account. Not worth the hassle.
I’ve been running an experiment with Prosper as well. I live in Oregon so I am unable to invest with Lending Club. I started investing in September 2014. Just like you, I am finding no correlation between the credit level of the loan and the default rate. I’ve only had one D-rated notes default, but I’ve had a dozen or so A and B rated notes default. Clearly, there is something wacky about the rating system at Prosper. I do not trust the data in the Prosper listings to be accurate.
Another thing: In several cases, it took over 2 weeks between when the loan was completely funded and when the notes were issued. That means my money was tied up for two weeks while the borrower attempted to get their paperwork in order. Prosper says that borrowers have 7 business days to get their paperwork in, but I’ve seen it go over 14 working days. Most annoyingly, many of these loans get cancelled so my money was tied up for weeks and I never got a dime for it.
I also have absolutely no confidence in the Prosper website. It has so many bugs and glitches that I cannot trust it. For example, it will sometimes take 10 minutes for my balance to reflect a purchase. That’s nuts. Right now I cannot open a listing for a note that is in default. I get a “System Error” message. Prosper says they’re aware of the problem, but in the past two months they haven’t fixed it.
On top of that, Prosper arbitrarily changes their rules. For example, Prosper no longer tries to recover defaulted notes. They just put them up for sale to collection firms at pennies on the dollar.
Worst of all, Prosper has no way to designate beneficiaries in IRA accounts. That means my heirs would likely have a hassle getting funds from Prosper should I pass away.
Based on my 14 months of experience, I have no confidence in Prosper and I have decided to NOT invest any more money with Prosper. I am unwinding my positions at Prosper by withdrawing cash as it become available instead of purchasing new notes.
Thanks for sharing your experience. I do prefer Lending Club to Prosper, but the main thing that pushed me that way was the inability to sell late notes at Prosper, which really isn’t a significant part of my strategy any more.
Since I posted my comment, two more of my Prosper notes have gone into default; one A rated and one B rated. Now I REALLY don’t trust Prosper’s ratings of their notes.
One more thing: It seems like Prosper is pandering to institutional investors. The interest rate and overall quality of the notes have declined significantly in the 14 months I’ve been running my experiment.
Since I cannot invest with Lending Club, I don’t know for certain, but it seems like investor’s at LC are happier than those at Prosper. If I was able to invest with LC, I would certainly give them a try.
Thanks for the post it is always good to see how your investment decisions have worked out. I personally feel that these types of non secured loans carry a significant increase risk vs private mortgage lending. I find I get similar returns however there is recourse if the borrower defaults ie you take over the property and sell it and recoup most if not all your money. It requires less management as you are loaning more but to fewer people. The tax implications are the same however.
Thanks for the information! I checked into Lending Club, and they don’t currently operate in my state (Oregon), they say due to state laws. However Prosper allowed me to set up an account. Any ideas on how they are set up differently in order for one to be able to function in OR? Does that make a difference to the investor?
I have accounts with both. I prefer Lending Club slightly, but if I had only had access to Prosper, I probably would have worked with that.
Basically, each of these companies has to go through a lot in order to function in any state. I don’t think there’s some issue that the State of Oregon is protecting you from.
I know there is full disclosure for the borrowers and all, but Peer to Peer lending just feels to close to the payday loans concept. The interest rates may not be as high but it still comes down to the idea of charging very high interest to high credit risk borrowers who shouldn’t really be taking these types of loans in the first place. I haven’t ever seen you recommend to one of the WCI readers who was in a tough spot to use a Peer to Peer loan. Using Peer to Peer loans seems to be putting ourselves in the position of the unscrupulous insurance salesman or high fee financial advisor. The rationalization starts to sound the same. The fact that there are so many defaults speaks to the lack of financial education and lack of financial resources of the borrowers. Instead of high interest rates or destroyed credit, they also need a fair shake.
Still love the site and your recommendations!
Keep up the great work!
I totally understand where you’re coming from and absolutely you’re right that I recommend AGAINST borrowing from Lending Club/Prosper etc. Truth be told, however, I recommend against borrowing for just about anything except for a home and medical school. At any rate, you’ll note that despite the fact that I get paid as much or more to bring Lending Club/Prosper a borrower instead of an investor, I’m not running those ads.
My rationalization/justification for investing in these notes is this:
I only invest in people who are looking to consolidate high interest debt (almost all credit cards) that is at a higher rate than the rate I’m giving them. No business loans. No wedding loans. No car loans etc. So I’m lowering their costs from 30% to 20%. Sure, it’s still not an awesome rate for them, but if they have someone willing to give them a great rate, they’re welcome to borrow somewhere else. I see myself as stealing business from banks/credit card issuers while helping borrowers get a little bit better rate than they now have. I can live with that. If you can’t, well, go loan money to the US government or “evil” corporations or people taking out hard money loans for real estate. Or live without fixed interest investments.
You mentioned you do Roth IRA, and P2P seems to be well positioned in a Roth space. Do they make it easy to make a back door contribution ? Could you post a quick tutorial?
I’ve been doing my backdoor Roth IRA at Vanguard. Then as needed to rebalance, doing IRA transfers to Lending Club/SDIRA. You’ve seen this, I presume?
https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
I haven’t tried a backdoor Roth IRA at the SDIRA/Lending Club. I try to keep things as simple as I can and I know it’s easy to do it at Vanguard.
I’ve been doing my backdoor Roth at Vanguard for the past 2 years based on that post, so I know it well. Thanks!
curious how you allocated your vanguard IRA before transferring it over to lending club. May just make sense to keep it in money market if I know that I will be transferring the whole thing?
Sure, if you’re going to transfer it. My timing of moving money from Vanguard to Lending Club doesn’t usually coincide with the timing of my backdoor Roth IRA. I’ve written before about my portfolio, but my Vanguard Roth IRA has some TISM in it but is mostly REITs now. I also have Roth IRA money at Bridgeway in their ultra small market fund. But keep in mind I look at all of my retirement money as one big account.
you mentioned that you use Interest Radar to do your actual investing. From my brief perusal of LendingClub.com it seems they offer and “automated investment” option with “full control of investment criteria.” Sow why use a 3rd party?
As I recall, that’s a new service. It wasn’t there when I first heard of interest radar. I haven’t compared the two to see if it is actually a better service.
[Post removed for spamming the blog. Seriously David, what made you think it was acceptable to post that same comment advertising your firm in multiple locations on the website?-ed]
Any rethinking of this based on the new Lending Club revelations about loan doctoring?
Yes, there has been a lot of thinking. Not much action though. I don’t make asset allocation changes lightly. There has never been any doubt that the biggest risk in this whole thing is company-specific risk.
James, I’m interested to know if you are still using LC after its recent stint in the headlines. From what I have read, it looks like the upper management is on the verge of turmoil & has received bad publicity as of late. I know that while you may not invest in the company itself (more so just in its subscribers), has the recent events led you to changing P2PL platforms or getting out of the P2PL space all together for now?
Yea, rough couple of months for the company, but the investments are still plugging along. I’ve spent a lot of time thinking about it but am staying the course for now. I’ve always known the biggest risk with this was the individual company risk. Maybe I’ll drop the asset class sometime when I simplify my portfolio.
“As mentioned above, the main benefit is the promise of double digit returns at a time when many experts think stocks may only return 3-7% going forward and bonds may only return 1-3%. $10K invested at 10% for 30 years equals $1.6M. At 4%, that only grows to $560K.”
Can someone explain to me how the math works for 10K turning into those numbers… I used a compound interest calculator and was not even close to those.
$10K invested each year for 30 years ($300K total) at 10% looks like this in Excel:
=FV(10%,30,-10000) = $1,644,940.23
I went to the LC site and one of their “read and agree to the following” states that you must have a net worth of $70k. I am only out of school two years and due to my student loans (already refi w/ Earnest), I have a net worth of only about +$9k.
1) There really is no way for them to know my net worth…so I could move forward anyway?
2) I assume this “rule” is in place to protect investors who can’t afford to lose money in a riskier investment, much like crowdfunding real esate sites have the >$1 mil net worth and/or >$200k income requirement. So should I stay away from both these investments until I’m further along with my portfolio?
1) I suppose so.
2) That’s correct.
I think your first investment dollars ought to be invested in index funds inside retirement accounts. If your net worth is $9K, I’d focus on boosting your income and savings rates before worrying about your asset allocation.
I already am maxing my Simple IRA through my employer. Considering I have this type of asset, I’m under the impression I cannot contribute to any other IRA due to the pro rata rule. What next type of retirement account would you recommend?
HSA if you have an HDHP. Then taxable. Then tell your employer to get a real retirement plan that you can actually put serious money into.
I can now invest in this in the State of Maryland. I decided to just try 0.005% of my savings to see how it works. If I lose it all no big loss, but am interested to learn more. Certainly possibility of a recession increasing defaults, but that’s true with many investments (just not as direct.) Thanks for sharing.
Thanks for the great post. Can someone elaborate on the tax disadvantage if using a taxable account. How do you invest in ROTH IRA and transfer from vanguard Roth
The interest payments are taxed at your full marginal tax rate. The defaults are a bit of a pain, but you can pull them in automatically from Lending Club with Turbotax, so that’s not such a big deal.
To use a Roth, either open one there or do a transfer from Vanguard.
Be aware before you start that I’m liquidating my account. Read more here:
https://www.whitecoatinvestor.com/why-i-decided-to-liquidate-my-lending-club-account/