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:
Upsides 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.
Downsides 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
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 It 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%!
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.
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.
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!