I joined Lending Club a few weeks ago.
This is not my first foray into the world of peer-to-peer (P2P) lending. Loyal readers (hi, you two!) might recall that I invested in loans through Prosper back in 2006 and 2007. You may also recall that I didn’t fare too well. Here’s my current account status:
To review: out of 28 loans, 11 were paid as agreed, and 17 were ultimately sent to collections or discharged through bankruptcy, where I either got pennies on the dollar or nothing at all.
Those investments were discussed previously in this blog:
So why am I back to P2P lending for more punishment? Well, a few things are different this time.
My mood towards the stock market has soured. I’m not confident stocks as a group can deliver their historical rate of return in the decades ahead. I’ve been out of school, in the work force, and saving for retirement since 1997. In that time the S&P 500 has seen a compound annual growth rate of 5.64%. I believe I can do better, but I’m also realistic about what’s truly possible. I’d feel successful if I earned 8-10%.
I’m investing with Lending Club instead of Prosper. Lending Club was the first US peer-to-peer lender to register its offerings with the SEC. They’ve had a number of years now to tune their business model. Regardless of how you might feel about the SEC, investing with a company that’s subject to some degree of SEC oversight is probably safer than a company that isn’t. I don’t blame Prosper — they were learning the same expensive lessons that I was and I truly feel they had altruistic motives — but I’m trying a different company anyway.
I’m investing through a self-directed IRA (SD-IRA). One of the biggest headaches I had with Prosper was dealing with the taxes once March/April rolled around. They basically act like 28 individual securities, which means a lot of typing into Turbotax. With the IRA account, I invest free of the taxes or tax reporting burdens I would’ve had with a regular account.
I’m dealing with lots of loans this time around. Instead of having $2,500 tied up in 28 loans at Prosper, I’ve invested twice the money ($5,000) in 7x the number of loans (~200 when fully funded). This spreads the risk amongst lots of individual borrowers.
Historical defaults are known, and I’ve factored them in to my expected rate of return. I invested in Prosper when the company was brand-spanking new. They were learning, and I was learning. Turns out their default rate was much higher than they anticipated, which destroyed return on investment (ROI). They didn’t have years of data to draw conclusions against. Lending Club does. There will be defaults, but since there’s an acceptable amount of historical data (in my opinion) to be able to predict default rates, I’ve factored defaults in to my expected ROI.
I dragged my feet on getting everything set up. There are a few more hoops involved in setting your Lending Club account up using retirement funds. The process isn’t difficult, per se, but neither the documentation nor the automation is where it needs to be to make it dead simple for investors of all ages and computer skills. The flows appear to be:
You ---(mail or fax)---> Lending Club ---(forwards to)---> SD-IRA Services
You ---(check or rollover form)---> SD-IRA Services ---(wires to)---> Lending Club
At the end of it, you end up with a Self-Directed IRA account at the aptly-named Self-Directed IRA Services and a Lending Club account. One interesting side-effect of having a self-directed IRA is that I can invest retirement funds in things like real estate, stock of privately-held companies, and tax liens.
One important note: if you want to do the Lending Club IRA thing, you need to use a special link on the Lending Club web site to kick off the process, and it’s not always easy to find. If you blow it and create a regular account, thinking there will be a place where they ask you what kind of account you want, then their support people have to delete it and you start all over again, which can take a day or two.
You can roll over part or all of an existing Roth or Traditional IRA over to SD-IRA/Lending Club, but I opted to make them my 2011 Roth contribution, which meant I just mailed them a check. I can’t comment on how smooth the rollover process is, but I’d expect they do a lot of them and it wouldn’t be any problem.
Once the forms were received and my check was cashed, I ended up with basically what amounts to 5,000 shares of my Lending Club account worth $1 each in my SD-IRA account (see below) and an available cash balance of $5,000 in my Lending Club account.
One of my problems with Prosper is that I ended up engaging in emotional investing. I read people’s sob stories and ended up investing a disproportionate share of my funds in their loan. Turns out those people default just as frequently as everyone else. Thus, Rules 1 and 2 were born.
Brian Rule 1: Nobody gets more than $25 from me.
Brian Rule 2: Ignore the stories.
Which is better: 25 loans of $200 each? Or 200 loans of $25 each? I don’t know; I’d say it depends on who the 25 loans are for. But I feel better having my loans spread amongst many people. As for ignoring the stories, time will tell on whether that’s a good idea, but if everything else is in place (additional Rules below), then I’m less concerned about how you acquired the debt as I am in your ability to pay off your loan.
Clicking Invest automates Rules 1 and 2 for you. It builds a portfolio of $25 notes (Rule 1) and it doesn’t read the borrower stories (Rule 2). What it does do is build portfolios based on your risk tolerance. It doesn’t discriminate between types of loans, though, so if you’d rather not loan to someone starting a business or needing to cover medical expenses, this feature probably isn’t for you.
As strange as it sounds, for the first $5000 I felt it was more important to get my money placed than to spend hours and hours vetting $25 loans one-by-one. I used the Invest function for the initial $5000, but after all was said and done with rejected or expired offers, about $3500 was allocated and the remaining $1500 was left over to reallocate. At that point, I decided it was time to get more particular about the loans and make some more rules.
Brian Rule 3: Invest in higher-rate loans.
Brian Rule 4: Focus on debt consolidations.
Brian Rule 5: Borrowers should have jobs. Even better if it’s for the government/military, and better still if they’ve been there for at least 1 year.
Lending Club’s historical data demonstrates that investing in higher-rate loans will net a higher return than “safer” loans when you subtract out the default rate. In other words (and speaking generally), which one would you prefer?
8.9% with 1% defaults = 7.9%
OR16% with 5% defaults = 11%
In my opinion, the answer is: it depends. If you play it by the numbers, and expect default rates to remain close to their historical values across all class of borrowers, then you’d chose the 16% portfolio. On the other hand, you might sleep better at night knowing only 1% of your loans will default, as opposed to 5%. You’re loaning real money to real people; it might effect you emotionally to have some of those people stiff you. You will want to minimize the number of defaults, even if it means a lower rate of return, just so you can sleep more soundly at night.
I tried to remain unemotional with Prosper, but it’s hard to do that when you read the borrower’s hard luck story before deciding to invest. Once the loans were funded, I found myself rooting for these people, even though I knew some of them would skip out on me. And sure enough, when a loan would go from 30 past, to 60 past, to 90 past, to Sent To Collections, I would scream inside “But you were one of the good ones!!! This wasn’t supposed to happen!!!”. Like I mentioned earlier, I made fewer loans with a higher amount-per-loan than I have with Lending Club, which didn’t help me divest myself emotionally. One loan defaulting hurt.
For my last $1,500 I decided to set up some basic filters in Lending Club’s Browse Notes screen. I wanted to exercise a bit more discretion in the loans I made, while trying not to become emotionally involved. This meant paying closer attention to the borrower’s statistics, while trying not to become too involved in their business. I screened for Debt Consolidation loans, for people with a steady job under their belt, who were mainly in the C/D range, with some B’s and D’s (and even a few E’s) tossed in there, those who had had their income verified by Lending Club, and where Lending Club had already approved the loan. Very few loans met all those criteria, and certainly not $1,500 worth at $25 each. I loosened the criteria some, relaxing the Approved status and looking at some loans that weren’t Debt Consolidation, and have been able to come close to funding out my full $5,000.
All told it will end up taking close to 3 weeks to fully invest my initial $5,000. Some loans I agreed to fund either expired before being fully funded or were rejected by Lending Club for some reason. When that happens, the money is returned back to me to reinvest, but days or weeks may have passed where that money was idle. It ends up being a fair amount of work to place all your money, but once it’s done, all you have to worry about is either re-investing the money people pay you every month or pulling it off the table and finding something else to invest in.
I’m still waiting on $150 to find its way into funded loans, but otherwise, as I mentioned, it’s taken me about 3 weeks to invest $4,850 in loans that pass my sniff test. You can expect that I’ll update this blog periodically with how it goes.
Update 12/20/2011: Peter Renton from SocialLending.net reminded me about lendstats.com. LendStats is not affiliated with Prosper or Lending Club; you could use it to do a sanity check against what those sites are reporting for performance. Here are my stats for my old Prosper loans.