About a year ago, I wrote a blog called "Show Me the Money: Six Strategies to Put Your Cash to Work," where I talked about two new(ish) investment strategies my wife and I were using. I wrote a followup blog about the first strategy, Electronically Traded Funds (ETFs), where I compared Betterment vs. Wealthfront. Now here is a followup on the second newish strategy that you're probably not yet trying out, but absolutely should be: Peer to Peer lending... or put another way: Lending money to complete strangers as an investment strategy.
I'm going to write this blog as a step-by-step how-to guide on trying P2P lending. Don't think you have enough money to become an investor? Wrong. Just set aside $25 to invest in each of the 2 biggest platforms. Seriously, who can't part with $50 to try something that will change your perspective on lending?
First, more on what P2P lending is:
OK, what's the catch?
Just like anything in life, there's are risks to P2P lending. It's important that you really understand what they are. I'm going to walk through each risk that I consider significant, and how to protect yourself against that risk.
Starting small: The ideal minimum investment size
OK so let's say you're like me and my wife -- you want to start small and see what it's like to put your dollars to work on a P2P platform. What's the minimum you should put to work? Like I said above, you can literally get started with $25 on each platform. So if you're debating between doing nothing vs. trying it, then literally just fund each account with $25, and fund two individual notes (the minimum investment size is $25 per note you fund). That's not the ideal minimum, however, and here's why: You want to diversify your risk across many borrowers, so if one defaults, it doesn't torpedo your returns. If you only invest $25 to fund one borrower, and that borrower defaults, then your return will be shot. There's a great article by LendingRobot that shows once you invest in at least 146 notes at $25 each (a total of $3,650), you have a statistically minuscule chance of earning a negative return. LendingMemo takes it a step further and breaks the diversification recommendations down by your risk tolerance -- they suggest funding a minimum of 200 to 300 loans (depending on the note's risk scoring grade level) at $25 each so you can get an expected positive return. 200 notes x $25 invested in each = $5,000. And there's another reason to start at a $5k investment level, as I'll describe below. So, to reiterate: Start with $50 just to experience it. But if you're really going to make this a part of our investment portfolio, invest at least $5k.
A side note about what "investing $25 in a note" really means: Let's say a borrower -- we'll call her Sally -- wants to borrow $10,000 to consolidate her credit card debt. She goes to LendingClub and applies for a loan. LendingClub will take that $10,000 loan and break it up into smaller chunks, and then offer each chunk to individual investors. So for example, Sally's $10,000 loan might be funded by 400 investors at $25 each. This diversifies the risk for everyone. If Sally defaults, those investors each only lose $25 -- a small part of their overall portfolio.
My wife and I use P2P lending for an aggressive part of our portfolio. Although we could choose to fund "A1" grade loans, we want to achieve a return of at least 10% annually, so we tend to fund D,E & F grade notes. In fact, as you can see in this screenshot below, LendingClub has over-allocated us on A,B & C grade notes, and can't fill our demand for the lower grade notes. This is typical because most investors who are putting money to work in P2P platforms want that higher return and are willing to accept the higher risk that comes with it.
But even in this under-allocated state, we are achieving a net annualized return of 11.89% -- and that's after accounting for defaults & charge offs! Here's what I mean: By investing in lower grade notes, we are expecting that a higher percentage of those borrowers will default on their loans, and subsequently, have their loans charged off. But that's why the interest rate on these notes is higher -- to account for the expected charge offs. LendingClub has issued over $9 billion in loans since it started. You can see from this chart that the charge off rate on all loans is 3.6%. When you diversify your portfolio by spreading $25 investments over thousands of notes, you're able to control for the variables that would otherwise be really scary, like "what if someone defaults?!" At these large scales, it all becomes a math equation: How much risk are you willing to shoulder in exchange for what level of projected return net of that risk, and then set your investing criteria accordingly.
And just like a bank or a credit card, if a borrow goes late, the lending platform will try to collect on the loan. For example, below an actual default from our portfolio. This borrower got a $12,925 loan from LendingClub. We pitched in $25 to fund that note. They stopped paying, and for 3 months, LendingClub tried to collect. They eventually charged the loan off, which negatively affected the borrower's credit score. We lost our $25 -- but not without a fight! And LendingClub did all the actual "fighting". (You can see a larger version of the screenshot here.)
Another reason to invest at least $5,000 is that once you do, LendingClub will turn on a feature they call "Automated Investing." If you invest less than $5,000, you have to slog through each available individual note, deciding which to fund. When you put $5k into their platform, they'll handle all the investment decisions for you based on the criteria you set, so it literally becomes a "set it and forget it" experience.
OK that's it for the "P2P Investing 101" part -- I encourage you to give it a try. Start with just $50 to experience it. Give it a solid try with $5k. Or get adventurous if you have the cash: Putting $120k to work on the platform will earn you $1,000/mo in interest income at a 10% return. (Important tax note: This income is taxed at an ordinary income rate, not a long-term capital gains rate, which reduces your net return... talk to your tax advisor, because I am certainly certainly not one!)
But wait, there's more -- here's the best part if you want to go deeper:
For the past year, my wife and I have been using LendingClub's "automated investing" function and happily earning an 11.89% return. But it was driving me crazy that we were under allocated in the notes we most wanted to get into. So I did some digging. It appears that we're not the only ones that have this idea. Hedge funds and other institutional investors have been using an API access layer to snap up notes the second they hit the market -- indeed, faster than even LendingClub's automated investing can pick them up. I wanted in on the API action! So I turned to a service called LendingRobot which hooks into both LendingClub and Prosper through the API interface. I've just recently begun experimenting with it, but the interface looks awesome. For example, I created two "rules" which define how we want to invest our cash in LendingClub. For example, one of our roles is to only invest in notes with a 14%+ expected return, and to borrowers not in FL, AZ, CA or NV (here's why). LendingRobot projects we'll make a 15% ± 7.44% return with these filters.
The second rule is for borrowers who have a mortgage (no renters, no outright homeowners) with zero inquiries on their credit reports in the past 6 months (here's why) with a 12%+ expected return. LendingRobot projects we'll make a 13% ± 6.56% return with these filters.
The downside of using LendingRobot is that they charge a 0.45% fee for providing this lightning fast API access and filtering capabilities, which has the net effect of reducing our overall return by that amount. It's too early to say whether the value created LendingRobot will offset that additional fee, but I'm willing to give it a try. For now, I've kept "Automated Investing" turned on in LendingClub while at the same time letting LendingRobot have access to the cash in our LC account. I figure if their API really is faster, they'll get access to that cash first, and if it's not, they won't. I'll report back after a few months to let you know how the LendingRobot returns are comparing against the straight LendingClub returns -- and I'd LOVE to hear any feedback from anyone who has experience using LendingRobot or any of the other automated investing P2P services springing up out there.
I hope you give P2P lending a shot-- and welcome to the sharing economy! Please leave a comment below describing your experience if you do try it.
I was having a convo over email w/ a buddy who's interested in this topic; he asked a few questions there that I'm re-posting and answering here so we can continue the convo w/ others who are also interested as well:
"have you seen many early repayments on your loans, and if that has impacted your returns?"
I just checked; it looks like 8.5% of the notes to date have been paid off early. LendingClub currently has my return at 9.96%, which includes those early pay-offs. LendingRobot, which as per above is more sophisticated, is projecting that the principal managed by LC will return 8.48%, and the principal now being managed by LendingRobot through the more sophisticated rules I've created will return 13.21%, a delta of 473 basis points, which is just insane. (As an aside, I have a hard time believing that LendingRobot's approach can really out-perform LendingClub's approach by that much, but as I mentioned earlier, I've started doing 100% of my allocations through the LendingRobot API as of a few months ago, so over time I'll be able to see if it bears out. If it does, it's incredible.) So yes, a large percentage of borrowers pre-pay notes, but I don't mind because that cash just gets put back into the bucket to be re-deployed, and since it's now being deployed by LendingRobot instead of LendingClub's algorithms, I prefer it that way since it should be re-deployed in more sophisticated ways.
"Also have you seen or used any of the secondary markets for these loans, e.g. https://www.lendingclub.com/
foliofn/aboutTrading.action? May be a way to end your Hotel California scenario."
Yeah I've tried them; they suck. Basically, there's a huge discount applied on the secondary market. It's not worth the hit. For now I've just made an assumption that the cash is a one-way door, and the only return of cash I'll be seeing will come in the form of interest income, and return of principal when the loan matures in 3-5 years (should I choose not to re-invest it). And I'm OK with that. It's just something to plan for as a part of an asset allocation strategy.
"It also looks like there may be some tax implications of P2P lending. From my very brief reading, returns on this appear to be taxed as personal, not cap gains, income. That means if you made 10% off of stocks at a 15% capital gains rate (until Donald Trump gets his chance to change it), you would need to make closer to 15% on lending club at a 40% tax rate to match the tax adjusted returns."
Yes!!! As I wrote above "Important tax note: This income is taxed at an ordinary income rate, not a long-term capital gains rate, which reduces your net return... talk to your tax advisor, because I am certainly certainly not one!" And you're right; it makes equities much more competitive. But even if the returns were exactly the same, I still see them as vastly different instruments: P2P investing is a way to generate passive income while putting cash to work. The only way that I know of to do that with equities is to pick stocks that pay dividends, which is fine, but I'm in equities for long-term growth.
Interesting: I asked LendingClub if API-based services like LendingRobot got earlier access to notes than through LendingClub's own Automated Investing service, and the person who responded claims they don't:
"API users and users who access the Lending Club website by manually logging in to their account both have identical access to loan inventory and data; there is no preferential treatment or special access granted to investors who access the Lending Club platform using the API. To learn more about API, please click here for our FAQ's"
However, in the week or so that I've had LendingRobot on, it hasn't had a problem investing the cash in my LendingClub account, which makes me think it does have some sort of priority level access. Additionally, this LendingMemo blog also talks about the speed of API access (although i believe comparing it to a human -- not to Automated Investing):
"The quickest investors were actually using high-speed investing servers to auto-submit their orders. Their orders were being submitted over API commands that Lending Club had made available, which basically meant these people are investing through pure server code. No graphics. No Google Chrome. Just bare-bones lightning-fast ones and zeros picking up anything that matched their filters. No wonder I was losing."
So... it may be that the API makes everything available at the same time, but LendingRobot is just better at snapping notes up quickly. Unsure -- would love to know if anyone has any perspective!
Great post, Daniel. I'd be interested to read a followup to this after having used LendingRobot for a season or two.
Thanks Simon -- love and really appreciate all the amazing resources you've put on LendingMemo -- thank you thank you thank you! I'll definitely provide updates on LendingRobot as we use it.
OK Simon, I have an important update on a huge difference between LendingRobot and LendingClub:
LendingClub pegs our adjusted return at 11.89%. But LendingRobot estimates that return will only end up being 6.66%. Meanwhile, LendingRobot is estimating that the return they'll get from investing our funds into LendingClub using the LendingRobot rules I set up is nearly double, at 12.67%.
Hum. Something's definitely off.
I asked LendingRobot customer service and here's what Gilad from their customer support department said:
"Our expected return is different from Lending Club's Net Annualized Return in a number of ways: We do a real IRR calculation on your entire portfolio; Lending Club uses the NAR, which is fairly non-standard; and they assume that all loans that are current will not default, which is unrealistic - we use the probability of default based on our statistical model, and adjust it over time based on the survival curve we calculated for historical loans (so if a loan starts off with 7% chance of default, as time goes by the chance of default decreases; if it has 2 remaining payments it's close to 0). You should therefore expect our expected return to differ from Lending Club's NAR."
So it sounds like LendingRobot is using a much more sophisticated (and possibly conservative) approach to calculating a return.
I also pinged the CEO of LendingRobot to confirm they are using the same formula to calculate both returns, and he said they are.
I'm going to be super interested to watch this closely. If LendingRobot truly can deliver almost a 2x return to just using LendingClub's automated investing service directly (something I find hard to believe is possible) then it's totally worth using LendingRobot for all our investment decisioning.
For now I'm going to keep LendingClub's Automated Investing turned on, as well as have LendingRobot turned on, meaning they'll both have access to our cash balance on the LendingClub platform, and either of them can use that cash to buy available notes based on the note grade criteria we've set on LendingClub, and the rules we've set on LendingRobot.
If anyone else has any comments or feedback on how good (or bad) LendingClub's or LendingRobot's return calculator is, I'd love to hear about it.
I didn't get a very straight reply from LendingClub on this, but here's what they said:
"With regards to your 11.89% return, please be advised that while it is impossible to predict the performance of any particular portfolio, there are many factors that can influence returns, including the number of Notes in your portfolio that correspond to different borrower loans, the concentration of your investment, the composition of your investment, and the performance of the loans corresponding to your Notes. Learn more about how returns typically change over time and the factors that can influence returns when you click here."
You should mention the relative "illiquidity" of the notes. Anyone who must have a substantial portion of there investment within a week or less shouldn't be in LC. (I was tempted to change "a week or less" to 'two weeks or less").
I've been a LC'er for several years and have not been disappointed. I recently joined Lending Robot as well.
Your article is the best overview I've seen for the uninitiated.
Here also is a great blog that highlights different P2P investment strategies: http://www.joejansen.co/blog/2014/8/23/lendingrobot-vs-nickel-steamroller-vs-lendingclub-automated-investing
Strategy "E" is very similar to the strategy I outlined above in the LendingRobot section:
Here's a great SeekingAlpha post that compares bonds to P2P loans: http://seekingalpha.com/article/1937421-bonds-vs-peer-lending-differences-in-risks
UPDATE: I've posted lots of updates since I originally wrote this blog 2 years ago. If you want to go deeper down the rabbit hole, check out this post comparing Betterment vs. Wealthfront ETFs and this one on Peer to Peer lending.
My wife Sue and I have been mulling over how to most effectively deploy cash in the current economic climate to generate decent returns without taking outsize risks. We've honed in on six main strategies, which I outline below in descending order of risk.
Since everyone has a varying amount of cash to invest, I'm going to specifically call out ways to deploy small amounts of cash in some of these strategies, as I want this post to be really actionable for anyone. The most important part is to just get started, and the biggest barrier to doing that is you thinking "I don't have any money to invest." So get yourself out of that mindset and jump into the world of being an investor, even if it's just with $25 (yes it's possible, below), $100, or $1,000 or $10,000, or whatever. I also recommend putting money aside every month to invest; that's a great way to get started.
Riskiest: Angel Investing
+P2P Lending has a history of high returns and low volatility, particularly for larger investors.
+The time and skill requirement is low, making it great for passive investors.
-It is tax-inefficient, particularly for investors of high risk loans
A unique way of investing that has been around for less than a decade is Peer-to-Peer Lending. In P2P lending, loan-seekers seek loans directly from individuals rather than banks (who loan money using deposits from individuals). This is how the process works: