I get asked quite a bit about Lending Club and other peer-to-peer loan investment companies. To those of you wondering if I have ever bothered trying these services, or include them in my family’s personal portfolio, the short answer: Yes. I do dabble in them. I underwrite a book of loans for my household as a way to augment the interest income component and add some bond-like assets to my private balance sheet while not introducing much duration (the loans are either 36 month or 60 month).
There are several reasons I don’t talk about peer-to-peer loan investments very often, or even alternative investments in general.
First, these types of securities are only made available to certain qualified individuals who meet the minimum requirements under the peer-to-peer loan offering terms. For example, the entire Lending Club platform is made available by prospectus, and there are threshold income and net worth requirements – this isn’t something the typical college student or young adult would probably meet as in all states other than California and Kentucky, you must have a net worth of at least $250,000 and / or a gross annual income of $70,000 combined with a net worth of $70,000 excluding your home, furniture, automobile, etc. The limits are higher in California. In Kentucky, investors must be accredited under 501(a) of Regulation D of the Securities Act.
Third, peer-to-peer securities are not fixed income replacements nor are they stand-ins for bank deposits as they are not FDIC insured. There is very real risk here. I don’t want a repeat of what I saw in 2008 and 2009 when you had people buying auction rate securities and thinking they were somehow the equivalent of safer, more stable assets. They are not. If we were to go into another Great Depression, it would be better to own 36 or 60 month certificates of deposit at a large, well-capitalized bank so the government-backed insurance would kick in if things went south; even better, to hold Treasury securities directly with the U.S. Treasury. This is a different animal entirely and they should not be confused. I know why I am buying these securities – they serve as a mechanism to have some non-equity exposure with short duration at rates above inflation for my family. They are not liquidity substitutes.
With that said, the appeal of peer-to-peer loans to me is intellectual as well as financial. It is a bit like underwriting insurance in the sense that there is a mathematical challenge; a given percentage of the loans absolutely will go bad and not be repaid. That is simply a fact; you can guarantee it. The question is whether or not the overall level and timing of those defaults (e.g., a loan that isn’t repaid yet has a high interest rate and a small amount of principal remaining isn’t nearly as damage as one that defaults a few payments in with a low interest rate), the weighted average interest rate, and the tax rules in place at the time can be arranged so that the overall result is more than satisfactory.
The Lending Club platform is the best I’ve found out of all of the peer-to-peer investment companies. When you examine the loan request documentation, it looks like this (see below). This is a loan request for $10,000 for debt consolidation that will have a payment of $343.09 per month, at an interest rate of 14.27%. The person earns $4,167 per month, has a debt-to-income ratio of 21.26%, has been employed for 2 years, has a 665-669 credit score, 1 delinquency in the past two years, no major derogatory public records, used 70.80% of the revolving credit balances available, and has credit dating back to 02/2001.
There were 219 lenders who subscribed to an average $45.67 worth of the loan to fund the entire $10,000. I subscribed for $25.00. That means that when the loan reached 100% funding, and Lending Club was satisfied with the documentation, it was underwritten and each of us received a part of the note.
Each month, when the person makes their payment to Lending Club, I receive my pro-rata share of the principal and interest since I subscribed to $25/$10,000th of the loan. Here is an actual breakdown of the loan performance for this particular note. Notice that this month, the person actually made the payment during the grace period. That might be concerning, but at the same time, his or her credit score also increased, indicating it might just have been a forgotten payment or they could have been gone on vacation.
To date, I’ve received $4.05 in interest income, plus $10.40 of my original $25.00 has been returned to me, leaving a principal balance remaining of $14.60.
The big key for it to work is adequate diversification. This is not an asset class in which you should strive to be particularly smart or take a focused approach. Like I said earlier, it’s more akin to insurance underwriting. Some loans will go bad. Some loans will default. It’s that simple. There isn’t a deep enough pool of liquidity to build up a loan book quickly – you’d have to ease into it for a year or longer, or be content to acquire some of the loans that are being traded between members on the exchange – so it’s definitely not a replacement for bonds or other, more traditional and safer fixed-income securities. Based on my review of the numbers, I think it would take a good 400+ individual underwritten loans to mitigate some of the non-desirable probability outcomes.
My small book of loans has been around for a couple of years and has a net annualized return of 12.52%. I have roughly 71% of the assets in B or higher rated debt, though I plan on increasing the percentage devoted to A grade debt substantially over the next few months. The lower grade debt I select is something I go through by hand; normally, I look for long credit histories without any delinquencies or public records, and where the underwritten loan is going to refinance most of the existing debt loan on the person’s credit report at a much lower rate.
Having played around with them for awhile, I do not recommend peer-to-peer loan investments as I think they are not the sort of thing the typical person is going to fully grasp the risks, nor does the median American household even qualify on income or net worth. These types of investments can be very dangerous. All I will say is that if you are a highly intelligent, above-average income, above-net-worth individual with a propensity for mathematics and enjoy taking intelligently structured speculative positions knowing full well that a misstep or sudden economic downturn could lead to partial or whole losses, you might consider Lending Club.
If you do though, make sure to click on that link because I get a free $25. (No matter how successful I am, I will never walk by a free $25. That’s like 0.37 shares of Nestlé for doing nothing but talking about a topic I was going to write about, anyway; financial icing on the cake. At my age, at average rates of return, that’s $2,935 by the end of my life expectancy due to the power of compounding. My grandchildren or foundation will thank you for the extra funds. Or, I do, if I decide, instead, to go buy a pound and a half of coffee or something.)