Lending Club Review for Borrowers and Investors

by Neal Frankle, CFP ®

You may have heard of Lending Club and to help you decide whether or not to use them, I’ve written an extensive Lending Club review.

They claim to be the biggest player in Peer-to-Peer lending. They could be right. As of 5/13/13 they’ve funded $1.7 billion in loans – with $140 million funded just last month.

Peer-to-Peer lending is an industry that matches people who have money with people who need to borrow money. The people who need money pay interest to the people who provide the loans. The interest rate borrowers pay corresponds with their credit history. The better the credit history, the lower the rate they pay with Lending Club.

Borrowers flock to Peer-to-Peer lending because they can often borrow money cheaper than from other sources. For many, it’s a great way to solve debt problems. A typical situation is one that a person has a need to borrow money through Lending Club at (let’s say) 7% in order to pay off credit cards that are charging 15%. The borrower shaves some interest off their payments and the lender makes a lot more than the bank is paying….theoretically. So while this investor hopes this is going to be one of their best investments, the question remains; Is it safe?

Before I answer that question, I need to walk you through the steps of how peer-to-peer investing through Lending Club works. As an investor, you open an account and deposit your money. Then, you select loans you want to invest in based on how much interest you want to earn and how much risk you are willing to take. Each loan is ranked by perceived risk. An “A” ranking is the most secure and an “G” ranking is the least secure. These ranks are awarded based mostly on the borrower’s credit score. This is the part I am a little uncomfortable with.

Don’t get me wrong. I love companies like Lending Club for borrowers. It’s a great business idea. And if I needed money and/or I needed to find an alternative to credit card usury, I’d be the first in line to apply for a loan. If you owe money, you could potentially save a huge amount by refinancing your debt through Lending Club.

But I’m cautious when it comes to investing with this or any other Peer-to-Peer lending firm. I did a little digging and came up with questions. Then, I spoke to Rob Garcia, Senior Director of Product Strategy of Lending Club to get his take on my concerns.

1. Default Rates

Your investment performance with peer-to-peer lending will be a function of how many loans in your portfolio default. That’s why the default rate is critical. When you invest with Lending Club, the notes are usually for a minimum of 3 years. Loans are ranked “A” through “G” to approximate the risk of default. Some time ago, I read on the site that the default rate for Lending Club is averaged for all loans 120 days or older. Sounds good, but my understanding is that the default rate for consumer loans increases with age, even for those who have high credit scores. (I looked on the site and couldn’t see any details about default rates per se other than that the overall default rate is 3%.)

Most Lending Club loans are for 36 months (minimum) and they have far more new loans than old. That’s because they are growing quickly. Lending Club is doing a good job of growing the company. As I said, they issued over $140 million in loans last month alone. So my fear was that the actual default rate may be different than the 3% the site reports. Here’s why:

Say I open an account and make 100 loans in my first year, 200 loans in my second year and 500 loans in my third year. I “invest” as little as $25 per loan so I can easily get lots of diversification. Let’s say that the defaults are zero in year one, 5 in year 2 and 15 in year 3. If you just look at the results for the third year, my default rate is 15 out of a total of 800 loans or 1.875%. That’s not too bad, right? Well that’s not accurate is it? Here’s why. If those defaults are all from the first batch of loans, we’ve got a real problem. If that’s the case, the default rate is 15/100 or 15%. You see where I’m going? The default rate of all loans over 120 days may not mean a lot. And remember that if the loan defaults there is a good chance you’ll lose everything – not just the interest. Ouch.

What would be more helpful would be to know what the default rate is per loan quality per year. They might show this on the site and I didn’t see it but I did look pretty hard and didn’t find it. Also, they might show it in the prospectus but I’m pretty sure most investors aren’t going to look that hard even if they do present the data there. To be fair, the site has a clear risk disclaimer suggesting that investors read the prospectus. They highlight the risks of borrowers failing to repay the loans. When I evaluate mutual funds, I look at the yearly performance. Why can’t I have similar information with peer-to-peer lending?

I brought this up with Rob and he made a pretty convincing argument. First, he told me that in order to even be considered for a loan, borrowers have to have at least a 660 credit score or higher. That weeds out about 50% of all the applicants. Next, potential borrowers can’t have any late payments on their credit report for the last year. That dismisses another 25 % of the applicants. In all, Rob told me that only 10% of the people who apply for a loan at Lending Club actually get funded.

The average Lending Club borrower has:

  • A 706 FICO score
  • 15.8% debt-to-income ratio (excluding mortgage)
  • 14.6 years of credit history
  • $70,794 personal income (top 10% of US population)
  • Average Loan Size $13,076

He went on to say that investors who are most successful at Lending Club are those who buy at least 100 notes (minimum investment is $25 per note) and the site shows statistics for investors with 800 notes ($20,000 total invested). His argument is that these people with a very large number of notes diversify away the risk of having any one bad note impact their overall portfolio. His experience was that if a loan was going to default, it would typically go sour before the end of the 9th month. This is of course no guarantee. But if true, it sort of takes care of my concern over the aging of the loans.

Rob wasn’t done. He also told me that Lending Club uses debt collection practices on all borrowers who default. This runs the gamut between making nice reminder phone calls, to working out a payment schedule to legal recourse. It’s nice to hear if you’re a lender, you still have a chance of collecting after the loan defaults.

2. Continuity

If Lending Club were to go out of business, what happens to the money you lent the borrower? How are you going to get your money back? Do you suddenly find yourself in the personal debt collection business?

When I spoke to Rob about this he assured me that Lending Club was solid. But even then, the company does have a plan “B”. They have an arrangement with a large established debt collection firm (Portfolio Financial Servicing Co) that would step in should Lending Club step off. That was also reassuring to me .

3. Lots of Work

I was worried about having to do a lot of work to find good loans. It takes time to go through the hundreds of available loans to find people you are comfortable loaning money to. Everyone has a story and you have to be able to read between the lines to determine who is full of it and who is a legitimate person. Oh, and by the way, with all due respect, who’s to say you know what you are doing?

Assuming you aren’t a skilled loan underwriter, you may keep selecting people with a good story but may end up shoveling money towards the worst risks possible. On this front, Rob informed me that investors can pick their own loans. But they can also use tools on the site that selects loans based on filters investors select. Mr. Garcia said that when investors use those tools, it doesn’t take much time at all to get a diversified portfolio of loans.

I was thinking about introducing Peer-to-Peer lending to clients about a year ago. Before I did, I put my own money into the system. I will tell you that Lending Club has done exactly what they said they would. They are a very professional outfit and I haven’t been disappointed by their service. But are personal loans good retirement income investments? Rob Garcia was able to answer my questions. He is smart and thorough. If that’s any indication of the people at Lending Club, I’ll be the first to admit that I’m impressed.

Again, I feel very comfortable with peer-to-peer lending for borrowers, and Rob answered all my questions. For investors, there are more risks involved with Lending Club but a well diversified portfolio can make sure the burn is not as bad as the overall gain if a borrower defaults.

At the end of the day, it takes years to really know the ins and outs of any particular investment and that’s the case with Lending Club and other peer-to-peer lenders. My experience tells me that while Lending Club seems to be a reputable firm, there is still reason to go slow. Think back to the golden age of real estate when uneducated investors threw money at homes they couldn’t afford for reasons they couldn’t explain. The reality of real estate came home to roost and many people got smacked down pretty hard. They same thing happens to many investors who put their money into investments they don’t fully understand.

This is not a simple investment and the risks are different than commonly perceived. For borrowers, this is a slam dunk. If you need money and you are paying high rates, Lending Club is a company I can endorse. But if you are looking for a “safe” way make 9% – don’t kid yourself. That’s because anytime you are offered rates that high, the risks are high as well.

I also want to be transparent – I am affiliate of Lending Club and I advertise their services. They pay me when people borrow or lend using their system.

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