+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:
- The P2P Lending platform takes loan applications from prospective borrowers.
- Accepted applications are quoted an interest rate, and fees.
- Loans open for funding are posted on the platform with borrow information, and dozens of other data. Here is an example of what that looks like.
- Investors browse loans with the help of filters and can ask certain questions.
- Investors decide which loans they want to fund and how much (minimum $25).
- Once investors fully fund a loan, the money is loaned out and first payment is due in 30 days.
Lending Club takes 1% of all borrower payments.
The much bigger cost is taxes. Interest income is taxed at ordinary income rates just like bond dividends. P2P lending gives interest yields similar to high-interest (junk) bonds, and are just as risky. Thus, Lending Club is best for an IRA account.
My Experience With Lending Club
The bulk of my loans were made in 2011. My youngest loans were made in Feb 2013. I do not waste time scrutinizing loans. I set my filters and invest $25 per loan until I am out of money. Just like how I don't believe I can pick stock winners, I also don't believe I can pick bond winners. I just invest as fast as I can click, and this is the result
The 9.01% measures the projected return of invested money. It is an overestimate because:
- When loan payments come in, they sit idle until withdrawn or reinvested.
- Some of my loans haven't defaulted yet, but will.
The second point becomes less relevant as loans mature, particularly after the halfway point, when most defaults have already occurred. But since loan payments can't be automatically reinvested or withdrawn to a savings account, there will always be some money doing nothing in your account. Your true ROI is closer to your Net Annualized Return* less 1%.
My Filter Set
I've refined my filter set several times as better data analysis became available. I mainly used Nickel Steam Roller. Although past performance does not guarantee future performance, relying on gut and logic is even worse. My latest filters are:
Credit Grade: D,E,F,G
- Home Ownership: Mortgage, Own, Rent
- Loan Purpose: All except Other and Small Business).
- Inquiries in the last 6 months: <3
- Debt to Income (DTI) Ratio: >5%
- Exclude loans with public records: Yes
- Exclude States: AZ, CA, FL, GA, IL, NV
- Months since last delinquency: >24
- Revolving Credit Balance: > 4000
- Monthly Income: > 4000
- Revolving Line Utilization: 10 - 100
You can test these at Nickel Steam Roller like I did. I also signed up for the 30-day free trial from Interest Radar and used their filter sets as well.
LC's recent growth has attracted institutional investors who use algorithms to invest in loans as soon as they become available. LC still rejects 90% of all loan applications, but the ones that are approved get funded easily. This imbalance of supply and demand worries individual investors, and also makes it difficult for them to re-invest. In response, investors must either
a. loosen their loan criteria and invest in less desirable notes
b. wait longer for loans to become available, idling their cash for longer
c. invest larger sums per note, reducing diversification
LC's collections team I feel could be better, however I understand that US laws are strict in protecting debtors against loan collectors, and a more vicious collections department would result in more overhead and may offset the gains from additional loan recoveries.
LC is tax-inefficient because interest payments are not capital gains. There are other reasons, but basically, the income is added onto your tax bracket and you are taxed at ordinary rates, just like you are with corporate bonds. Thus, IRAs and Lending Club go together like beans and rice.
I only use Lending Club as a passive investment, as my $25 investments per loan do not justify the time to actively scrutinize, buy, and sell loans. I am happy with my 8% returns with less volatility than stocks. I am unhappy that my income will be taxed at ordinary income rates.
*This is LC's Net Annualized Return formula: