Why I Said “No” to Peer-to-Peer Lending

Recently, investors in my state ^a)Lendingmemo.com lists the current availability for each state became eligible to invest in peer-to-peer lending at Lending Club, so I decided to investigate whether it was worth pursuing.  If you are considering this as an investment, please read this post and other reviews first.  I will link other reviews at the end of the post.  Most of this post is from content I drafted for a page I am working on at the Bogleheads wiki site. ^b)The wiki has a lot of useful investment information, and I highly recommend both the wiki and forum.

Peer-to-Peer (P2P) lending is a collaborative way for individual investors to participate in lending activities previously limited to banks. There are two major U.S. companies providing mature lending platforms, Lending Club and Prosper.

Key elements are:

• The P2P companies have done well because they can screen borrowers according to stringent lending standards but also provide loans more efficiently than banks. Accurate risk ratings with associated interest rates are posted for investors’ consideration.
• The P2P company issues “notes” to individual investors, who can invest small amounts (as little as $25 each) to diversify across hundreds of loans; investors are charged fees of 0.5% to 1% of the note’s value, which are deducted as principal and interest are paid.
• Notes are available in two term periods, 36 months and 60 months.
• P2P companies recommend holding at least 200 notes to obtain adequate diversification.
• P2P lending is regulated at the state level, and not all states permit investment. Some states limit investment only to Lending Club or to Prosper. Some states that prohibit investment permit purchase and sale of secondary market notes.

Risks

• Default Risk – Notes issued are unsecured loans and borrowers default more frequently.
• Single Party Risk – The P2P companies own the loans, issue notes to investors, then collect and disburse payments of principal and interest. Investors do not own the underlying loans. Therefore, in the event of a P2P company bankruptcy, the loans may be considered assets to the company’s creditors. Accordingly, investors should carefully consider the limits to investor protections for Lending Club and Prosper before investing.
• Interest Rate Risk – When interest rates go up, the market value of existing notes will fall in price because new notes can be found at interest rates more attractive than existing (lower interest rate) notes.
• Economic Risk – During poor economic conditions, and particularly during periods of high unemployment, default rates for notes could increase substantially.
• Liquidity Risk – Although there is a secondary market for trading P2P notes, market prices can decline significantly due to a lack of willing and available buyers. Investors holding notes to maturity do not incur this risk.
• Prepayment Risk – Borrowers may pay back loans early, so lenders reinvesting the proceeds may obtain less favorable rates. Additionally, Lending Club investors incur a pre-payment penalty because they are still assessed the 1% fee against the balance of their “pro rata share of the payment.”
• Competition from Institutions and Individuals – The available pool of attractive-rate notes has declined in recent years due to increased involvement by institutional and retail investors. While the number of P2P loans is increasing, investor demand has been greater. Accordingly, the average interest rate earned and number of loans available per retail investor have been declining since 2013.

Benefits

• The personal loan segment is a recently-available segment for retail investors, and provides a new way to add diversification within a fixed income portfolio.
• Investors who wish to actively manage their fixed income investments can now do so with P2P notes, even with limited capital.
• Given the small minimum investment per note ($25), a high level of loan diversification can be obtained.
• While lending standards were initially loose for P2P platforms, today they are more stringent. Additionally, P2P providers update their performance records, including loan default rates and returns, on a regular basis.
• You can filter loans by criteria that you choose, so you can “personalize” the risk characteristics for each individual loan you select. You can also select groups of notes that fit the amount of overall risk and return you prefer.
• Personal loans, while risky, provide a high return and different risks than other fixed income investments. For example, personal loan notes are different than high yield corporate notes.
• Some investors may find it fun to select the individual loans they wish to participate in, and cherry-pick certain loans to attempt “better returns.” There are differences to be found, even between identically graded loans.

Why I Declined

P2P is neither a simple nor a low cost investment.  Maintaining a large portfolio of individual notes would be a lot of work given the amount of money I would consider investing. If I were to invest $20K and earned 10% clear (and that is a very generous estimate), that is $2,000 per year.  But, I can earn 4% risk free (FDIC insured) using Consumer’s Union and 5% at Mango (no longer open to new investors).  The general principle I try to follow is to “take risk on the equity side” rather than with fixed income. Investors who might consider P2P useful could be those already including high yield (junk) bonds in their portfolio. P2P may provide them some additional diversification. Since I do not include high yield, I do not need that kind of diversification.

While the personal loan segment is a lucrative area previously limited to banks, it is not clear whether the risk adjusted return, after fees, provides a better risk-adjusted return than comparable investments, such as high yield bonds.

Most importantly, the deal-breaker for me was that P2P is a concentrated investment because of its single party risk.

If You Dare

For those who venture into P2P, limit total investment in P2P to a very small part of the portfolio (no more than 5%). Also, note that P2P is not tax-efficient and should be located within tax-advantaged accounts. Lending Club does permit IRA accounts, so it might work that way, but now you would have another IRA account to manage.

P2P (and all high yield) investors should take a corresponding reduction in their equity allocation, since both have a high correlation with equity performance. If I were to invest, I would use a much higher number of notes (700-800) for a higher degree of diversification, and I would limit investment to only maturities of 36 months, no 60-month term notes. I would acquire notes gradually, over a 36-month period, so a ladder with a portion maturing every month can be reinvested at current rates. A final note of caution – if you decide to go with this, plan to hold all notes to maturity.  The secondary market is not very liquid.