Over the past couple of years I have been concerned about the possible effects of rising interest rates and have been looking for around for some alternative things to do with cash other than the typically fixed income (besides lining my crate with it).
I had been familiar with Lending Club for about a decade, but it took quite a long time for them to get approved to do business in Massachusetts. Lending Club falls under the category of “Peer to Peer” Lending and I will share my personal experience of burying a few bones with them.
“Peer to Peer”Lending
With Peer to Peer Lending , you can be a borrower or a lender. I chose the Lender route in order to diversify my investments and seek another type of fixed income.
“Lending Club connects people who want to take out personal loans (borrowers) with other people (investors/lenders) who want to earn returns.”
The idea is I get choose certain types of borrowers to lend money to in exchange for monthly repayments of principal plus interest at a certain rate based on the level of risk I’m willing to take. The level of risk is based on the person you are lending to, meaning their:
- Credit History
- Work history
- Do they own or rent
- Have they defaulted before, etc..
Individuals can invest through Notes, which correspond to fractions of personal loans facilitated on the Lending Club platform. Notes mature in 3 or 5 years. I did only 3 year loans as I didn’t want to go out any farther.
Notes can be purchased in $25 increments, so investors can easily build portfolios. For example, you can have a 100 different loans out for a cost of $2,500 at rates from 5-20%.
You’ll see a stated interest rate for each Note. That interest rate is what the borrower pays over the life of the loan and corresponds to the borrower’s “risk profile.” The higher the interest rate, the higher the expected risk of the borrower not repaying their loan.
So for example “A” rated loans are paying around 5% while a “D” is paying about 20%.
If you want 20% returns, this is the dude you will be lending your money to.
Your net returns are after charge offs, prepayments and fees. VERY IMPORTANT!
• Charge-offs –when borrowers miss their payments for so long that we formally recognized their loan as a loss.
• Prepayments—when a borrower pays more than their minimum required monthly amount, reducing the amount of interest you’ll receive over time.
• Fees—LendingClub charges a fee for servicing loans facilitated through the platform, as well as other fees in certain circumstances.
Example from Lending Clubs website:
My mistake, besides eating my owner’s favorite slippers, was getting more aggressive with Lending Club and not keeping as close an eye on it as I should have.
So I focused 100% on “A” notes when I first began and had a set of criteria for the quality of borrowers I would lend to. Over the first 9-12 months I had about 5 defaults, meaning these people failed to completely pay back their loans. Completely acceptable to me.
Well, I decided to go for a little more risk with B and C ‘s for higher rates and then didn’t keep an eye on it for a while. I was shooting for 8% and 9% rates on these.
Pow!! The default rates were much higher than I was used to or that I feel is acceptable. I’m still averaging over 5%, but am uncomfortable with risk/return tradeoff I was taking. You’ll notice the example above where lending club factors in a high percentage of defaults to get to a 5% return, but I would rather take lower rate/lower defaults to get essentially the same rate.
These days it seems harder to find the quality borrowers I prefer whether it is due to popularity or market conditions, I’m not sure. I feel “Peer to Peer” Lending is something that should be investigated by the curious investor really seeking further diversification on the fixed income side. So do your homework and only invest things you fully grasp and understand.