Peer-to-peer lending has been attracting a lot of attention recently. Companies like LendingClub* and Prosper have been growing rapidly. LendingClub alone has given out over $5 billion of loans. Although small relative to the more than $800 billion of credit card debt, these companies are quickly becoming important lenders.
At MagnifyMoney, we believe that interest rates on credit cards are too high. New entrants like LendingClub and Prosper promise to provide lower interest rates than credit cards, helping people pay off their debt quicker. We welcome new entrants, new competition and lower prices.
As a borrower, you have nothing to lose. You can see if you will be approved, and your interest rate, without receiving a hard credit inquiry on your credit report. Most importantly, you are receiving all of the same consumer protections as if you were borrowing from a bank.
But, if you are thinking about investing in the platform, you need to do your homework. Here are the seven things you need to know:
1. Your investment is not insured, and you could lose everything.
If you are a borrower, you are not taking any risk by borrowing from LendingClub or Prosper.
But if you provide financing for loans, you are taking a speculative bet. Unlike depositing your money with a bank, you receive no FDIC insurance.
And, if either LendingClub or Prosper go bankrupt, you stand in line behind every other creditor. The loans are not “carved out.”
So, you are not only taking credit risk for the individual borrowers, but you are also taking credit risk for the companies themselves.
2. The smaller your portfolio, the more your investment resembles a Las Vegas casino
Investing in a consumer loan portfolio only makes sense if you have at least 250 individual investments. Ideally, you would have more than 500 loans in your portfolio.
Fewer than 100 loans is gambling.
The minimum investment amount (per loan) is $25. That means you should be prepared to invest at least $6,250. Ideally, you should be investing more than $10,000.
The scoring models used to make the lending decision only work when you have a statistically significant population. Statistically significant usually starts at 250 loans. With fewer than 250 accounts, the model is unable to predict with a high level of certainty the outcome. That means greater volatility.
3. It takes a lot of good loans to pay for one bad loan
It helps to remember the math.
If you make a $100 loan, the borrower does not pay you back, then you lose $100.
If you make a $100 loan and charge a 15% interest rate, then you will be earning approximately $13 of interest during the first year (assuming a 3 year term).
So, just to break even during Year One (on a cash flow basis), you would need 7.7 good loans just to pay for the cost of one bad loan.
4. All types of diversification are important
It is good to have 500 loans in your portfolio. But, if all 500 are renters in Southern California with 660 FICO scores, then you do not have a diversified portfolio. Instead, you have a bet on Southern California renters.
To get the full benefits of diversification, make sure you have a portfolio that it well distributed by geography, score, and key risk criteria.
5. Three year is a long time; Five years is a lifetime
The “loss curve” of a consumer portfolio increases over time. That means very few people stop paying in the first six months. (If you see a lot of missed payments early, then you really should be afraid. Who doesn’t make at least their first payment?)
But the more time you add to an unsecured loan, the less likely someone will pay it back.
And there is very little data to show how consumer loan portfolios perform on LendingClub and Prosper in Years Four and Five because so few loans are that old.
As a risk mitigant, consider only making three-year loans. People who sign up for shorter loan payback periods are usually much lower risk.
6. Don’t forget common sense
Sometimes data can be deceiving. Before 2008, the data convinced the world that a “landscape architect” with a FICO of 550 deserved a $600,000 mortgage.
If you see a lot of credit card debt, and a lot of missed payments (recently), then you should not be afraid to feel a little nervous in lending.
Despite years of science, data and analytics, the single best predictor of future repayment is historic repayment. Don’t be afraid to question the score and eliminate accounts where you see high levels of debt and missed payments.
7. This can be an interesting part of your portfolio, but only the speculative portion
There is still very limited data for both Prosper and LendingClub. The investments are speculative.
However, consumer-lending assets can be extremely profitable, if you have a well-diversified portfolio originated by a quality lender. I believe that LendingClub and Prosper can offer those opportunities.
But, just to prove the opposite, I decided to build a portfolio that ignored all of the advice above. I only invested $1,000. I largely targeted the higher risk customers (< 700 FICO). I am a few months into the process, and one of my loans is already heavily delinquent. So, to date, I have received $19.88 of interest. And I will have a loss of $25. My investment is in the red.
I like the platform, and am now ready to take my own advice and build a more diversified portfolio (less speculative), of maximum 36-month loans. But I am only going to invest an amount that I feel comfortable losing.
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