I have been reading a lot of gloomy remarks about peer to peer lending around the web. Some of them are valid concerns and complaints, but most in my opinion simply show a lack of understanding and education. I have a feeling that many people jumped on the bandwagon of investing in peer to peer lending without fully understanding. I sure did, but I also committed to learn more about this new opportunity. My attempt with this blog has always been able to keep me honest about my investments and in turn educate myself (and hopefully maximize my own personal returns along the way). I’ll review a few of these concerns in this post and I welcome any discussion in the comments section.
Like any other industry, peer to peer lending has evolved. In fact, that probably isn’t even the correct term to be using. Industry leaders are now calling it “Marketplace Lending” and yes – it’s true. Institutional investors are throwing money at this industry like you wouldn’t believe. Take a look at the below charts courtesy of Nickel Steamroller – you can find more here.
It’s pretty clear that a majority of these loans are getting allocated to the whole loan pool for institutional investors, but that doesn’t mean that retail investors like myself are being pushed out. Prosper has recently made changes to their API bidding policy to give retail investors maximum access to review and bid on a listing. Even without this, I haven’t had any issues keeping either my Lending Club or Prosper accounts fully funded.
Lending Club Data Changes
As both Lending Club and Prosper have started to mature there have been many changes and among those is borrower privacy. Anytime there are reduced data field available, it brings out a flood of complaints. For instance, not too long ago they decided to not display full zip codes. With the most recent change, they removed almost half of the data points. You can read more about it on Lend Academy’s post. Borrower privacy I can understand, reduced transparency I can’t. (I was happy to find out that P2P-Picks, which I use for almost all of my note selection will not be affected by this change.)
No Good Prosper/Lending Club Notes?
I often read it is harder to pick ‘good loans’. I’m shocked at how many people believe that they posses the ability to pick better notes (at release time) than the next person without taking the time to do analysis on their strategy. If you’re sitting at your computer 4 times a day trying to pick up loan then yes – perhaps you aren’t finding what you’re looking for. I’ve written about almost every automated investment tool out there and have also compared them with Lending Club’s automated investing tool. The excuses to not automate are dwindling as with the new Lending Club REST API, you won’t need to provide your Lending Club credentials.
Nickel Steamroller has back testing filter capabilities for both Lending Club and Prosper to determine filter criteria which may increase returns. If you’re a more a hands on investor, go ahead and create a custom filter and then automate it. If you’re not, leave your loan selection criteria up to a true expert like P2P-Picks or try out a newcomer to note selection – PeerToPeerQuant. Keep in mind that Lending Club CEO has stated many times that there are no best notes. That doesn’t mean there aren’t opportunities for arbitrage. (improve)
Sub-par Returns with P2P Lending?
I think it’s interesting when people compare p2p lending returns with those of the stock market. There are arguments on each side, but I think the key here is that p2p lending is a fixed income investment. One of the huge benefits is the cash flow and it shouldn’t be subject to swings like we see in the stock market. I would argue that p2p lending is a good diversifier to equities. I anticipate in another 08-09 scenario, defaults would rise, but I’d still be left with a pool of relatively high quality borrowers who will continue to make payments. Nickel Steamroller pegs the ROI overall during 2007/2008 as -3.44%/-0.27% respectively. Simon from LendingMemo made some excellent points regarding returns in a recent post.
However, often when I read about sub-par returns it most often comes down to a lack of diversification. According to the Lending Club website:
With just $2,500 you can spread your investment across 100 Notes. 99.9% of investors that own 100+ Notes of relatively equal size have seen positive returns.
Others recommend at least 200 notes to be fully diversified, but I still think the above is important to know. You can’t start investing in p2p lending with a mere $1,000 if you are buying new notes.
Speaking of diversification, Lending Club states you you should not have more than 10% of your investments allocated to p2p lending. Although I have a fair amount of money allocated to marketplace lending, I also own a number of index funds including stocks (both domestic and international), bonds and a REIT fund. I also own physical real estate. If something were to happen to either Lending Club or Prosper or a majority of the 1000 people I invested in – I would still be fine.
Peer to Peer Lending Investments are Illiquid
It’s true, you can’t simply cash out your entire p2p lending account as you would with a stock or a fund. However, there is a secondary market and with enough patience you will be able to sell your notes and I’m aware of others who are trying to solve this issue. For now, I’d like to offer another viewpoint from Carl who has a lot riding on p2p lending:
Lending Club notes are essentially short duration bond surrogates. The very shortness of their duration provides liquidity. If people need funds immediately there is FOLIO. (I know they may take a slight “hit” but in an emergency the liquidity is there).
I’m learning this firsthand – the subject of a future post.
Peer to Peer Lending is Tax Inefficient?
I can understand the complaints about tax efficiency with marketplace lending. This is because the income is taxed as ordinary income and the losses are capital losses. However, it is easily mitigated if you open a Lending Club IRA. I personally like having the option to withdraw the steady principal and interest payments if needed, but in the future an IRA with them is something I would consider. The money I have allocated in p2p lending would otherwise be sitting in a bank account earning nothing. Note: I’m not a tax professional.
P2P Lending is Investing in Low Quality Borrowers
Based on my research I’ve found that in general, sub-prime borrowers are those with FICO scores under 620-640 (although other factors are considered). Prime is usually stated at being around 720. The range of borrowers varies widely across both platforms, but I think it’s important to realize that you don’t have to invest in the higher risk borrowers. If you aren’t comfortable with the risk, then stick with A-B rated borrowers. Saying that investing in peer to peer lending is investing in financially irresponsible is a disservice to what this industry actually is.
According to the Lending Club website, as of June 30, 2014:
As of June 30, 2014, the average Lending Club borrower shows the following characteristics:
700 FICO score
16.7% debt-to-income ratio (excluding mortgage)
15.7 years of credit history
$72,751 personal income (top 10% of US population)
Average Loan Size: $14,056
Say what you will about marketplace lending, but if you’re going to invest – please get educated. I’ll leave you with words of wisdom from Carl who echos my thoughts:
Get educated. Learn from your mistakes and prepare to spend some time. There is a reason that there is a sharp movement into marketplace lending. Hedge funds, mutual funds, family offices and wealthy individuals are after good stable liquid returns. And most important they are investing time to get educated.