Peer to peer lending as an investment is new, and there isn't much data out there. To make things worse, the companies occasionally tweak their methods for rating loans, their methods to decide who they lend money to, and the interest rates at which they do so. That makes the limited data that we do have suspect for predicting the future. But that's no excuse not to at least take the data into account. Here are 7 tips to help you increase your return at Lending Club.
1. Look at the Data
Both companies put some data on their website. However, they present it in the best light for them. It's best to go to an independent source of data. One of my favorites is Lendstats.com, which shows data for both Prosper and Lending Club. You should also check out Eric's Credit Community (more Prosper data) and Lending Club Stats (more Lending Club data). The interfaces aren't always intuitive, but once you figure out how to use them, there's a ton of useful data you can use to guide your investing.
Remember to diversify. Each of these investments, even the best rated ones, are high-risk. In my general opinion, you're loaning money to people either too uninformed or too unreliable to borrow at the rates available to most either through mortgages, home equity loans, business loans, auto loans, and introductory credit card offers. That doesn't mean most of them won't pay you back, but don't be dumb and loan money to just a couple of them. At $25 a pop, there's no reason to not own dozens or hundreds of loans.
3. Lower Your Expectations
Sure, you see all these loans out there that are offering interest rates of 15-25%. You're probably not going to get those kinds of returns. According to lendstats.com, the average return on Lending Club loans originated since mid-2009 is 6.4%. Now, 6.4% is still a decent return (especially if you can increase it by following these tips), but it's not mind-blowing.
4. Loss of Liquidity Correlates With Higher Returns
Using the time period noted above, 60 month loans have had a return of 7.9% compared to 5.7% for 36 month loans. Yes, neither set of loans have run their full term, so the data is quite suspect, but there's a trend there that might be worth exploring.
5. Higher Risk Correlates with Higher Returns
If you want high returns, you need to play with the lower quality loans. Keep in mind at Lending Club that most of the lower rated loans are rated that way because they are 60 month loans. But if you isolate that out using the filters at lendstats.com, you see a trend even among the 60 month loans. A rated loans returned 4.9% versus 11% for the F and G rated loans. If you look at the 36 month loans, the risk/return relatonship persists, although isn't as strong. For example, A rated loans returned 5.2% increasing to 6.3% for D rated loans.
6. Choose the Right A Rated Loans
Most loans seem to be A rated. If you want to minimize your defaults, these are the loans to invest in. Most of these are 36 month loans. The average return on 36 month A loans since mid-2009 is 5.2%. But you can increase this significantly by using certain criteria.
- Lend to mortgage holders- Surprise, surprise. People who can get their ducks in a row enough to qualify for a mortgage are a better credit risk than those who cannot (or do not.) 5.5% returns for mortgage holders, 4.7% for renters.
- Avoid car loans, business loans, “green” loans, and vacation loans- I see the logic behind each of these. For example, even an A rated Lending Club loan is a lousy rate for a car loan. Most dealerships are offering loans at 0-3%. Why would someone take out a 6-9% loan for a car if they have a great credit score? Because they don't qualify at a dealership for some reason you can't see. That's concerning. Based on the ads I see, dealerships seem to offer credit to just about anyone. Business loans- Remember one can only borrow up to $35K at Lending Club, less than that if you want an A rating. If one can't scrape that much capital up to start his business, how likely do you think that business is to survive? And how well thought through is the business if the funding plan is Lending Club? Not a good sign. Green loans- Saving the environment is a lousy reason to take out a loan. And taking out a loan to go on vacation? That just shows the mentality of the person you're loaning money to. Who do I like to loan to? Debt consolidators and those trying to pay off their credit card loans. The motivation is obvious. They're got 15-30% credit card loans and they can consolidate them at 6-9%. That's a smart financial decision, and hopefully shows they're turning a corner in their financial sophistication. Not only do I feel good about getting a solid return, but I can feel good about helping others find financial independence.
- Ensure adequate income- It's easier to pay back loans when you have decent income. When you have to choose between putting bread on the table and keeping the lights on and maintaining your credit score, guess which one loses? The cut-off for A rated loans seems to be about $4K a month. More than $4K gives you a return of 5.6% and less than $4K gives you only 4.2%.
- Adequate credit history – I now understand why banks deny mortgages to people without much credit history. For some reason, A rated borrowers with less than 5 open lines and less than 10 total lines of credit have a lower return than those with more adequate history.
- Don't worry about delinquencies- This one is hard for me. It seems it would be a good idea to not lend to those with a history of not paying money back. But this one illustrates an important point about these peer to peer companies. You have to keep in mind what the companies have already done. For example, delinquencies affect your credit scores, which Lending Club uses to begin their assignment of loan rating, so they're already “baked into” the risk/return spectrum. You actually get a slightly higher return lending to A rated borrowers with more delinquencies in the past, the more recent the better. However, keep in mind that perhaps Lending Club is getting it wrong. For example, if you use just credit score among A rated borrowers, you see the higher the score, the higher the return. It turns out that FICO knows what they're doing.
- Go for the big loans- This one again seems counterintuitive, and part of the reasoning is due to the Lending Club methodology. Lending Club LOWERS the loan rating for larger loans. So you get the same quality of borrower, but with a higher interest rate on a large loan. Among A rated borrowers, a $1000 loan has a return of 1.8%, but loans over $25,000 have returns > 7%. Part of this might be a function of income, but not all of it.
How much of a difference can it make to use all of these tips? If you lend only to mortgage holders, avoid car, business, green, and vacation loans, set a minimum of $4000 income, require 5 open lines and 10 total lines of credit, use a minimum 750 credit score, and only fund loans bigger than $20K, you can increase your return on A rated borrowers from the average 5.2% to well over 7%. Of course, there have been less than 150 total loans that meet those criteria in the last 2 1/2 years, so you're probably going to have to make a few compromises (or be very patient) to actually find loans to fund.
7. Choose the Right Risky Loans
This is the real secret to making money. You've got to select the high interest borrowers that won't default. Here are a few tips culled from the database of past performance. The overall return on D-G loans is 8%.
- Lend to mortgage holders- Same as with the A borrowers, those with a mortgage are better risks at 9% returns versus 7% for renters. The really strange thing is that those who own their homes outright only give you a 5.4% return. The only explanation I could come up for this is the fact that if you own your home and can't get a home equity line of credit at something better than 15% (which is about where these high interest rate loans start), you're probably a lousy credit risk.
- Car loans are now okay- While they have a lousy return for A borrowers, they have the best return among D-G borrowers at 12%. I guess those with really bad credit can't get those dealership loans and maybe somehow tie the car they need for their job together with paying this loan off, even though in reality the loan is not secured by the car. You still need to avoid business, green, and vacation loans of course. Go for the debt consolidation loans, credit card loans, and surprisingly, wedding loans.
- Income still important- Ensure at least $3000, preferably $6000 a month for the best returns.
- Credit history still important- Ensure at least 5 years of history and at least 3 open lines of credit. FICO score not so important in this group.
- Delinquencies are okay, bankruptcies are not- Beware the public records, even 1 bankruptcy or judgment is a very concerning sign. Beware of recent delinquencies, however. Make sure there aren't any in the last 6 months.
- Larger loans are still good- Aim for loans bigger than $15,000.
- Take advantage of the liquidity bonus- 36 month loans return 6.5%, but 60 month loans return 9.4%. At Lending Club, you get more interest for the same credit quality by selecting the longer loans. It takes an extra 2 years to get all your money back, but you shouldn't be investing any funds at Lending Club that you need anytime soon anyway. This isn't the place for your emergency fund.
How much can you increase your returns by using these selection criteria? You can increase relative returns by 50%, from the 8% average to over 12%. Caveat Emptor, of course, as past performance is no guarantee of future performance. But if you want to invest in the best evidence-based manner, that's the evidence you should be most interested in.