As regular readers know, I’ve been messing around with peer to peer lending. I first opened an account with Lending Club back in October. In February, I opened an account with Prosper.com. I haven’t put much money there yet, only $500, which at the $25 per loan minimum, only gives me about 20 loans.
The main attraction of Prosper over Lending Club is better returns, at least with Prosper 2.0. Prosper was the first of the two big peer to peer lending services, but the initial investments were a disaster. They shut down for a quiet period, revamped the system, and started lending again in July 2009. Since then, returns have been much more promising.
Using lendstats.com, you can see that for loan originated between July 2009 and December 2009, the average Prosper return has been 8.4%. That’s several percent better than Lending Club from the same time period.
My goal with these peer to peer investments is not to ensure safety of principal. I know a significant percentage of these loans are going to default. This is not money I need for decades, so I can afford to take some risk. This is also an incredibly illiquid investment. It would be a major pain to get my money back anytime soon. But it is also an investment from which I expect high returns, and very low correlation with the rest of my portfolio. Not only do I want these 8% returns, I’m hoping that by using back-tested data from lendstats, that I can actually improve on that by 2-4% or more and get double digit returns. Here is the method I plan to use to do that.
1) The Repeat Borrower
If the future resembles the past, then I can increase my return by 3% simply by only lending to people with previous Prosper loans. 9% for everyone. 12% for repeat borrowers. That’s pretty low hanging fruit. The problem is that there aren’t all that many of them. There might only be 2 or 3 repeat borrower loans to fund per day. So if you want to invest $5000, at $25 a piece, that’s 200 loans. It might take you three months to build that portfolio. That’s a lot of time, effort, and money sitting there earning you $0 until it’s invested.
2) Riskier Loans
I don’t even touch the AA and A loans for the repeat borrowers. The average return for an AA repeat borrower for loans originated since July 2009 has been 4.6%. That jumps to 11.8% for a B borrower, and as high as 17% for an HR borrower.
The curve is a bit more complex for the first-time borrower. Returns for AA and A borrowers are around 6%. B-D borrowers have had returns of 8-10%. But at the far end of the curve, with the E and HR loans, it drops down to around 7%. So you’re looking for the middle of the range.
3) Longer Loans
Prosper offers 1 year, 3 year, and 5 year loans with corresponding returns of 4%, 9%, and 12%. That’s a pretty hefty liquidity premium, and I plan to take advantage of it. Like the repeat borrower loans, the 5 year loans are also a bit rare, so it is hard to fill a portfolio with them.
Just like with Lending Club, loaning to those who own their home seems to be a better bet. That may just be because they’re less likely to declare bankruptcy, but it at least shows that they can get their finances together enough to buy a home in the first place. Homeowners 9.6% on average, renters have an average return of 8.4%.
5) Have a Job
Seems like a no-brainer I know, but apparently some people looking for loans on Prosper don’t have a job. Some are retired, others are unemployed. It turns out that the highest returns are from those who are self-employed (9.8%) and employed (9.2%.) The unemployed and “other” folks have returns around 4%. It’s even better if they make more than $50K. You don’t want someone choosing between putting food on the table and paying you back.
6) Avoid Business Loans
Just like with Lending Club, you don’t want to lend to people starting a business. Businesses fail, and when they do, so does the income of the person starting it. No income= no loan payments= loss of your investment. Returns for business loans are a couple percentage points lower than loans for other purposes (around 7%).
7) Reasonable Credit History
While the credit score doesn’t seem to matter much, and delinquencies and bankruptcies don’t make much of a difference, you don’t want to loan to people that haven’t borrowed much. Look for at least 5 open credit lines, 10 total credit lines, and a 2 year history.
This strategy is all from back-tested data. The future may not resemble the past, especially with Prosper continually tweaking their models. But investing without looking at the evidence seems stupid when the evidence is so easily found. I”ll keep you updated as I go along. If you’d like to tinker as well, click on one of the links on this page. It doesn’t cost you anything and I get a small commission when you open an account.