Yes you read the title correctly–For nearly a year I have been investing in an investment that I believe will produce about a 12% long term average annual return for me. No, this is not a get rich quick scheme or some kind of gimmick but rather a relatively new kind of investment that I am excited about and want readers to know about.
The investment is peer to peer loans. Peer to peer lending companies such as Prosper and Lending Club find borrowers who are looking to borrow money at rates cheaper than what banks will lend to them at and match them up with investors who are looking to earn a higher return on their money and are willing to fund their loans.
These companies handle the initial underwriting and screening of borrowers, tax reporting, and other administrative tasks and charge a small fee for their work. The rest of each loan payment (net of Lending Club and Prosper’s small fee) is then passed on to investors.
Benefits of Investing in Peer to Peer Loans
High Potential Returns
Investing in peer to peer loans has the potential for earning very high returns, even in a very low interest rate environment. Well diversified Prosper and Lending Club investors have generally received higher returns than they probably would have on most other types of notes and bonds. Average returns may even be higher for some investors than their stock market average annual returns.
Good Historical Performance
Well diversified peer to peer lending investors have historically made good returns and rarely lost money. I would guess that the average peer to peer investor’s long term investment return is around 7-9%. However, that is just the average return. I’ll explain in a minute how I do much better than this and how you may be able to as well.
Assistance with Due Diligence
Peer to peer lending sites such as Lending Club and Prosper generally perform an initial screening of the loan applicant. Only a very small percentage of applicants actually pass the underwriting process and are eligible to receive loans–most applicants are actually rejected due to poor credit.
Borrowers who pass the initial screening have at least decent credit (if not much better). Historically, most borrowers have paid back their loans responsibly, even during the recent recession. This is why returns are so high. However, there are no guarantees and some borrowers do default. That’s why it’s important to spread your investment among as many different loans as possible.
Approved loan applicants are assigned a credit rating, which determines the interest rate charged on any loan they receive, and provides clues to investors about how risky a borrower that person is.
Personal Due Diligence
Peer to peer lending sites such as Prosper and Lending Club generally provide a lot of information to potential investors about those looking to borrow money, making it a very transparent way to invest. Investor’s can see the borrower’s income, employment status, credit score, credit history, and other important information to help make an informed decision about whether to lend money to this person or not.
Peer to peer loans have excellent diversification potential, since they tend to have low correlation to many other common investment alternatives, such as stocks or bonds. Even when the stock market was tanking in the recent recession, many peer to peer investors were still making decent returns.
Easy to Understand
I generally recommend to people that they only invest in things they can understand. Most people understand the basics of peer to peer lending without much difficulty.
Quick and Easy
Low investment minimums (you can invest as little as $25 in any loan) and automated diversification options make it incredibly easy to invest in hundreds of different peer to peer loans in no time at all. Additionally, I have found the Lending Club and Prosper peer to peer lending sites to be very intuitive and easy to use.
Low Hurdles to Invest
An investor is generally able to lend part or all of the money any borrower wishes to borrow. Investors must invest at least $25 in any loan they choose to invest in but they can invest more. Investors can pick and choose which loans they want to invest in.
By having such low investment minimums, it is quite easy for even investors of modest means, to create a well diversified peer to peer loan portfolio.
Peer to Peer Lending Facilitation
Let’s say you want to try and make money by loaning funds to other individuals. However, let’s say you decide to do everything on your own without the assistance of a peer to peer lending company such as Prosper or Lending Club. This might involve you having to do all of the following (and more):
- Screen potential borrowers and judge their credit worthiness
- Decide who you are willing to loan money to and who you are not
- Based on an approved borrower’s credit worthiness and other terms of the loan, decide on an appropriate the interest rate to charge
- Come to an agreement with the borrower on these terms
- Create a legally valid agreement
- Monitor and keep track of payments
- Take care of any applicable tax reporting
- Coordinate collections efforts in the event a borrower stops making payments
As you can probably guess, doing such a task yourself with only one borrower would be a lot of work and would be tough to do efficiently. Now imagine you want to create a diversified portfolio of loans and need to do the above for hundreds of different loans.
Alternatively, if you decide to use a peer to peer lending firm such as Prosper or Lending Club rather than spend the energy and time trying to manage this yourself, most of the heavy lifting is done for you.
Peer to peer lending companies facilitate the process for both parties, making it a much more legal, efficient, and secure way of doing things.
Improvements Over Time
Peer to peer lending companies started in 2006, with Prosper being the first company. Lending Club entered shortly thereafter. Both companies have improved their models and matured over the years and are now more experienced with assessing potential borrowers and choosing proper interest rates. Their online platforms have also improved greatly over now.
It used to be that Prosper and Lending Club notes were very illiquid. However, they both have secondary markets now where you can sell your notes. Some people sell notes strategically in order to generate higher returns (mature, high interest paying notes oftentimes sell at a premium) while others simply use it when they need to generate liquidity.
Downsides to Investing in Peer to Peer Loans
Like any investment, there are some downsides to investing in peer to peer loans. It’s very important to understand the pros and cons of any investment you may be considering. I personally believe the pros far outweigh the cons but there are cons nonetheless and they are real and need to be understood.
Peer to peer loans are not a risk free investment and you could lose some or all of your investment. The main risk when investing in peer to peer loans is that a borrower will default and stop repaying his or her loan. Your overall returns will be lowered each time a borrower defaults since the loans are unsecured.
There are borrowers who default in every credit class. Even some people with pristine credit will default. Defaults on newer loans lower your returns more than defaults on older loans, since there will be a larger loan balance outstanding.
Peer to peer loans are more risky than other some other types of loans or notes. Many investors are willing to accept this higher risk for the chance to earn a much higher return on their investment.
Similar to other fixed income and cash vehicles, inflation eats into the purchasing power of your returns. However, the opportunity to earn high returns with these loans does help.
Lending to Strangers
Although you can find out quite a bit about any potential borrower, you are lending money to a complete stranger.
Peer to peer loans are generally unsecured. If a borrower doesn’t make his or her payments, Prosper and Lending Club do everything within their power to get the borrower to pay (including using collections agencies, taking people to court, etc). However, if they are unsuccessful and the borrower defaults, you may be out the remaining loan payments you are owed. This is why I personally invest no more than $25 in any single loan.
Lack of Historical Data
Peer to peer lending is still fairly new and so Prosper and Lending Club historical data is fairly limited compared to more traditional investments. However, it does look very promising so far. As with just about any investment though, past performance does not guarantee future returns.
Peer to peer lending companies have to be compensated for their facilitation of the loans, and so there are some fees involved. I personally think the fees are very fair for the services performed, but they are fees nonetheless, and they eat into your overall returns.
My Personal Investment Strategy
Now that I’ve given you some background on investing in peer to peer loans and shared the pros and cons with you, I will now share with you how I generate very high returns with Prosper and Lending Club. My strategy involves the following:
- Invest in notes in the riskiest credit grades
- Invest in the best notes possible within these credit grades
- Diversify as much as possible
- Invest in a tax efficient manner
- Keep my cash balance low
- Automate my investing
1. Invest in Notes in the Riskiest Credit Grades
The notes in the riskiest credit grades can pay interest as high as 25 – 30%. The least risky credit grade may pay interest of around 8% or so. However, as you can imagine, riskier notes tend to have a higher default rate than less risky notes. However, what I’ve noticed though is that the higher interest received on riskier notes more than compensates you for the higher default rate you will experience.
For example, the average interest rate on all of my loans is over 22%, yet I believe my average annual return over the long run will be around 12% after factoring in fees and defaults. The least risky notes may pay interest of around 8%, but a portfolio of these notes may generate average annual returns of around 5% after factoring in fees and defaults.
2. Invest in the Best Notes Possible Within Credit Grade
The quality of the notes within each credit grade can vary pretty dramatically. For example, in a risky credit grade, there may be a borrower who has had multiple bankruptcies, has been delinquent on payments several times in the past year, is currently unemployed, has a high debt to income ratio, and has only had credit for 5 years.
In the same credit grade, there may be another note paying the same amount of interest where the borrower has never declared bankruptcy, has never been delinquent on a payment in the past several years, has been employed at the same job for 5 years, makes $50,000 a year, has a reasonable debt to income ratio, and has had credit for 15 years.
Which one of these notes would you want to invest in? Which one is more likely to default or at least have trouble making their payments? The answers are obvious.
Let’s say the average annual return for a portfolio of notes in this credit grade is 9%. However, a portfolio of notes exactly like the first may have an average return of only 6% whereas a portfolio of notes exactly like the second may have an average return of 12%. I outperform many of my fellow investors by investing only in the higher performing notes within each credit grade. Filters and automatic investment options make it very easy to do this if you don’t want to manually choose each loan.
3. Diversify as Much as Possible
We have all heard that we shouldn’t put all our eggs in one basket. This goes for peer to peer loans too. If you want to reduce your risk and increase your returns when investing in peer to peer loans, consider diversifying your investment among hundreds or even thousands of different loans to reduce the impact of defaults.
Think about it–if you invest in only 4 different loans and one borrower defaults, you’ve likely suffered a huge loss. However, if you invest in 400 loans and 6 borrowers default, your losses are minimal.
I personally make the minimum investment allowed ($25) in as many loans as possible. If I have $5,000 to invest in peer to peer loans, I don’t fully fund one $5,000 loan. If that person stops making payments I could lose everything. Instead, I invest $25 in two hundred different loans. This can help diversify away part of the risk of borrower default.
I further diversify by investing in both Lending Club and Prosper’s notes. Each has their own underwriting methodology and credit grades, so I further diversify by using both of them.
4. Invest in a Tax Efficient Manner
As a CPA, I’m always concerned with how any earnings on my investments will be taxed. A tax inefficient investment could cause an otherwise great investment to lose some of its luster.
If you invest in peer to peer notes in a taxable account, then your earnings will be taxable as ordinary income. In order to avoid having to pay taxes (now or in the future) on any of my earnings, I invest in Prosper and Lending Club through Roth IRAs. Traditional IRAs are also available.
5. Keep My Cash Balance Low
Whenever I add money to my account or receive loan payments from borrowers, there is cash sitting in my account not earning interest. In order to prevent this cash drag from lowering my overall return, I invest this cash as quickly as possible into new notes. Automated investment options can help greatly with this.
6. Automate My Investing
There are plenty of options for automating your peer to peer lending investments. You don’t have to spend hours and hours pouring over the profiles of borrowers, trying to decide which loans to invest in. Instead, you can set up filters of the types of loans you want to invest in and then have Prosper and Lending Club automatically invest your money in such loans once they become available.
For example, you could set a filter to invest in loans where the borrower has income over $50,000 a year, has never had a bankruptcy, and has never been late on a payment in the last few years. I use multiple filters and switch them up from time to time in an effort to earn higher returns.
My Personal Experience
As stated above, I’ve been investing in peer to peer notes for nearly a year. The average interest rate of the loans I’m invested in is over 22%. My net annualized return after factoring in notes that have already defaulted, is about 18.5%.
However, 18.5% is not a very accurate forecast of my long term average return since I have other borrowers that are behind on their payments (30 days, 60 days, 90 days, etc) but have not yet defaulted. Not all of these borrowers will default (some will get caught up) but some of them likely will. Once I factor in the likelihood of these people defaulting, my current adjusted net annualized return is closer to 13.5%.
It’s very normal for an investor’s annualized returns to drop over time, especially in the first year or so. When you first invest, borrowers won’t have had a chance to miss any payments and so your adjusted net annualized return will be about equal to your net annualized return. However, over time, some borrowers (generally a fairly small percentage) will get behind on their payments and some will eventually default.
Factoring this into account, I project my long term average annual return will be closer to 12%, even though it is currently at about 13.5% and has been there for quite some time.
What This Means for You
As you can probably tell, I am a big fan of investing in peer to peer loans. I’m very excited about the returns I’ve seen in my first year as well as the potential for high returns over the long term. I’ll never make 25% in a year with it like I potentially could in the stock market but I don’t think I’ll ever lose 25% in a year either like I could in the stock market.
I expect my average returns in peer to peer loans to be around 12% whereas I expect my average annual returns on my stocks to be only around 8 or 9%. Obviously these are only estimates and are not guaranteed in any way. I also believe peer to peer loans to be a fantastic way to diversify my other investments in stocks, bonds, real estate, etc. There is a reason why hedge funds and institutional investors are pouring money into peer to peer loans at an incredible rate. They see the same potential that I do.
As of the writing of this article, U.S. stocks are near all-time highs and interest rates on bonds are near all time lows. I personally believe it’s possible that the stock market could experience a correction in the near future. When interest rates start to rise, existing bond portfolios may take a beating. So I’m very grateful for the diversification I have with my peer to peer notes.
Although I think everyone should be aware of peer to peer lending, only you will know whether it is right for you. If you do decide to invest in peer to peer notes, you probably shouldn’t invest your entire investment portfolio in it but rather only an appropriate percentage. Most people would be wise to keep a diversified portfolio, spreading their investments among stocks, bonds, cash, and possibly a few other types of investments, such as real estate and peer to peer loans. Within peer to peer loans, you should also diversify among as many notes as possible rather than roll the dice on only one loan.
Remember, you can always start small and then increase your investment if you find it beneficial. If you are also very risk adverse, you can reduce your risk even more by only investing in the least risky notes.
Can I guarantee that if you invest in peer to peer notes that you will receive the exact same returns as me? Of course not. Your returns will depend on the notes you invest in, just like mine do. But I have shared with you how I invest so that those interested in following my strategy can do so.
How to Start Investing
Although they do have their differences, the similarities between Prosper and Lending Club greatly outweigh their differences. You can probably do well with either company. For additional diversification, I split my investment between both.
Once approved, investors are able to transfer money to their peer to peer lending account from their bank account. They are also able to see information about the many approved borrowers and their desired loans and decide whether or not they want to invest in a given loan.
Once the desired amount of funds has been raised for a given borrower, the loan is funded and the borrower begins to make payments of principal and interest back to the investors.
What are your thoughts about peer to peer loans? How has your experience been with Prosper and/or Lending Club? Leave a comment below!