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. 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 and that’s true with Lending Club.
Borrowers flock to Peer-to-Peer lending because they can 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) 9% 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 “F” ranking is the least secure. These ranks are awarded based mostly on the borrower’s credit score.
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 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 “F” to approximate the risk of default. I read somewhere 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. According to Rob, they issued over $18.5 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 a loan shop and make 100 loans in my first year, 200 loans in my second year and 500 loans in my third year. 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? But 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.
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 and highlighting 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.
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 through 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.
- More information on how to borrow with Lending Club
- More information on how to invest with Lending Club
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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{ 8 comments… read them below or add one }
Neal,
Good article and I agree with many of your points. Here is my response to your three main points:
I did a study of default rates on my blog in January which shows a breakdown by grade of defaults.
One other thing I would like to say about defaults. Not all defaults are created equal. In your example above you stated a 15% default rate. This does not mean you lose 15% of your principal. Far from it. Because borrowers are making principal and interest payments all the time, the defaults that you get in year 2 and year 3 of a 36 month loan will have far less impact on your investment than a default in year 1.
2. Lending Club has an agreement with a loan servicing company in case of a bankruptcy, so investors will not be left on their own. Having said that, no one knows exactly what would happen in a bankruptcy of Prosper or Lending Club, there is no legal precedent. But I think a Lending Club bankruptcy is highly unlikely given their growth rate.
3. I have $100K invested in peer to peer lending and I do about half an hour of work each week on my investments. It doesn’t have to be hard. There are automated plans offered by Lending Club and Prosper, but I chose to do quantitative analysis where I invest in loans that meet my strict criteria. All this analysis and filtering is done in Excel.
I agree that p2p lending is still a somewhat speculative investment. But I think it is good for more than play money. It is a diversification into an asset class that consumers can not have exposure to elsewhere. This is why I recommend people commit 2-5% of their portfolio to it.
Dear Peter,
Your response is as interesting as the article. Regarding your 3rd topic, it would be interesting to see your excel analysis.
Thanks,
Rudy
Rudy, It is a pretty simple process. I just download the CSV file of the in-funding loans and load into Excel. Then I take my filtering criteria and use Excel’s data filtering capabilities. The 800 notes or so are usually reduced down to 10 or 15 that I then invest in.
Great article, these were my concerns going in as well.
I maxed my first year to $1000 just until I learned the ins and outs and I can not wait until january when my personal promise is up and I can invest more (I realize I should just put more in now, but rule #1 is stay disciplined).
Overall I have found that I am very care about loan reasons and only give loans to people who would be paying monthly for something anyways (such as a car, or credit card debt).
Someone who is used to paying $500 a month on credit cards and can now pay $350 is a lot more likely to repay.
I also only invest in loans <5k in total.. again if the monthly payment is only $100 – $200 then its easier for them to make vs. it being closer to 1K / month.
I have been investing with lending Club for the past few months. I am not financial analyst but to mee I find the approach is simple and straight forward. I do not put more than $25 in any one loan and try to spread it in different groups. I think this is a far easier concept to understand than stock market and mutual funds. As in any business act with caution, asess you risk tolerance.
Another comfort I feel is even when I lose money invested some of those I feeel better to know it went soe ordinary guy trying/ struggling rather than stolen by some croks disguised as bank executives.
Folks on the Investor side should note that they are -NOT- buying the underlying debt. They are buy a Note from LendingClub, which is matched to the loan.
Those loans are NOT pledged to secure the Lending Investment.
If Lending Club goes bust, the loans are still serviced, but the money goes to ALL creditors — FIRST to secured creditors of the Lending Club, and THEN to unsecured creditors. Investors in the LC Notes are UNSECURED.
If Lending Club goes bust, the loans may be collected but the money does not go to the investor directly.
Why is this important? LendingClub operates in the red EVERY year, and only survives by selling stock. If it stops selling stock, it’s over.
Why is that important? Because if LendingClub can’t offer any prospect of making money, it will not be able to attract folks to buy STOCK, and if they can’t do that, they business is done, and investors in the LC Notes are out of luck.
You did NOT ask: What assets are pledged to support the preferred stock offerings that keep getting sold, lately? I would be that THOSE FOLKS will get their money back, FIRST, and the loan investors LAST.
Prudent, You raised a good question. I asked Peter Renton of Social Lending Network this question. This is how Peter responded:
Yes, these are unsecured notes from LC/Prosper, not the borrower. This is why I study the financials of both companies closely. Most of the VC money they have received is equity, they have very little debt on their balance sheet outside the lender notes.
If I see a build up of other debt I will become concerned, but I don’t think that will happen. Both companies are well aware of the fact that the big investors want to see them profitable.
If the firms were to go under right now, I would guess that investors would receive at least 75% of their investment and possibly more simply because there is no debt on their balance sheet. It is always something to keep in mind but I don;t lose any sleep over the possibility of a bankruptcy. Both firms have enough capital on hand to see them through to break even.
Peter Renton
Publisher
Social Lending Network
http://www.sociallending.net/
I heard about Lending Club a little over 2 years ago and decided to put in some money. I invested $1k, distributed it amongst $25 notes (a mix of 3 and 5 year timeframes), and left it alone. I had read a few articles suggesting that with P2P lending (or really, I guess with any kind of lending) your initial returns may not be indicative of longer-term returns. So I also decided I was going to hold off on putting in any additional money or reinvesting my returns until my initial batch of loans had been out for at least 2 years.
For the first 18 months, things seemed to be going GREAT, my net return was around 13%, everything was getting paid on time, hurrah.
In the past 9 months, I have noticed a definite slide in my portfolio performance, with my net return now standing at around 8%. I’ve had 3 notes charged off within the past 6 months (out of 42 total), and there are a couple more that are in some state of lateness right now–I’m anticipating I will probably see several more chargeoffs before all is said and done. I have also had 5 notes paid off early. While this at least means I can’t lose money on those notes, it also means they are not offsetting the bad loans as much as they might have otherwise. There also doesn’t seem to be much of a pattern in whether or not the riskier loans are the defaulters/late payers–I have “A” grade loans that seemed very solid go into late payment about as often as the “riskier” C-D loans.
I’ve made a bit over $600 back at this point, and unless things really go south, I don’t see myself coming out of this with a net loss, but I also don’t think it’s quite the money maker they are spinning it as. In the current economic climate I’m not too upset, there aren’t really a lot of good investing options out there right now, savings account interest rates are way down, etc. If I come out with a 5% return (which I still think is possible), I’ll be happy. However, I probably won’t be putting a lot more money in any time soon, or if I do I’ll be counting on a MUCH lower return rate than what is initially projected.