I first heard of peer to peer lending from some of the finance podcasts I listen to. I think it was this episode of Listen Money Matters that first introduced me to the concept. I got really excited about it. I’m always looking for new ways to invest and this sounded like a novel way to diversify my family’s portfolio. A year and a half later, my wife and I are starting to pull our money out.
Now, this little experiment with Lending Club has not been a disaster. Far from it. We’re still earning healthy returns from our small investment of about $2500. But we’ve shifted our stance and no longer think it’s the right investment for us. I’ll share why in a moment. First here’s some background info.
For those of you who don’t know
Peer to peer lending is a way for regular Joes like me to lend money to individual borrowers and earn interest as they pay that money back. Platforms like Lending Club and Prosper and the miracle of the World Wide Web made this possible.
“It’s like we’re the bank,” I said to my wife, way oversimplifying it. “Finally! We get to be the Fat Cats! Why not put some of our money in and see how it goes?”
Lending Club (the peer to peer platform we chose) handles underwriting and collections for the loans. They slice the loans up into $25 “notes” which investors like me buy to help fund them. Because you only own a small part of each loan you invest in you can spread your risk over many different loans. As money starts coming in from borrowers paying back their loans, you can take the money and run or reinvest the money back into additional notes
The loans are graded A through G. Grade A loans are considered much less risky than Grade G. My wife and I bought little $25 pieces of more than 100 different loans. Being the high rollers we are, we went for the more risky loans (C through G, heavy on E) because they offered higher returns to investors. Some Grade G loans carry a more than 30% interest rate!
Investors will never see 30% annualized returns, for a variety of reasons, including loan defaults and Lending Club fees. But 8-12% is not out of the realm of possibility.
That sounds pretty cool, you’re thinking. I’d take 12% annually on any investment.
That is a nice return. But, of course, it isn’t guaranteed.
Nothing’s guaranteed at 12% This isn’t 1973!
Okay. Okay. Great point! Here are the other reasons we’re exiting the platform:
Less return… More risk?
Lending Club’s average annual return is actually not 12%. Sure, it’s possible to get 12%. But investors are currently averaging more like 5-8%, according to Lending Club’s own statistics. We’ve currently got an adjusted annual return of 6.8%, once Lending Club factors in likely defaults.
Sure, the stock market is volatile in the short term, but volatility isn’t the same as risk. Long term, the stock market has been as close to a sure bet as anything, consistently bouncing back from hard times and delivering healthy gains. That’s no surprise, since the stock market essentially represents the sum total of human productivity and ingenuity. We’re plucky little beings, it turns out.
It looks like there’s less to gain with Lending Club. And much more risk. With peer to peer lending, you are investing in unsecured loans taken out by people, who, in many cases, haven’t been very responsible with their money.
That risk and the fact that the average gains for Lending Club don’t beat even the most vanilla stock market portfolio in the long-term is one reason we’re stepping away.
Fees and taxes
Stock market investing wins here too. Maybe as the peer-to-peer matures, this will change. But right now, expect to pay a 1% fee and up to 30% in taxes (depending on your bracket) on your Lending Club gains.
Contrast that with the minuscule 0.05% fee charged to my Vanguard Total Stock Market Index Fund (VTI) and 15% capital gains tax for long-term investing.
That’s a significant difference. Fees and taxes make Lending Club less appealing.
Lack of true liquidity
You can liquidate your Lending Club position without waiting out the terms of the loans (Loan terms are 36 month or 60 month, by the way. Most are 60 month). But selling Lending Club notes is not nearly as easy as selling stocks.
I’ve never sold Lending Club notes on the secondary market. We plan on cashing out as payments are made and the loans mature. But, fortunately, Jonathan Ping from My Money Blog does a great job explaining how it works in this post.
One of the things Ping says that stuck with me, is that the notes that have had a previous late payment are really difficult to sell. Note buyers “seem to avoid [them] like the plague, even if they revert back to current,” he says. “If you really want to sell those last few loans, you may have to put them up at significant discount of 10% or more.”
The lack of true liquidity here is hard to swallow.
I have no doubt that the vast majority of Lending Club borrowers have every intention of repaying their loans. But shit happens. And the more I thought about it and put myself in borrowers’ shoes, the more uncomfortable I got about our Lending Club investment.
If I got in severe trouble financially, my Lending Club bill is one of the last bills I’d pay. For some people it might even come behind cable. What happens during the next economic recession when borrowers have to make the choice between paying their Lending Club obligation or putting food on the table… or catching Season 7 of Game of Thrones?!
We don’t really know how Lending Club borrowers will act in times of severe stress. We’ve got a small sample size through The Great Recession. That’s good enough for a lot of investors, but not for me. I have no doubt there will be a rash of loan defaults during the next downturn.
What if 50% of your borrowers suddenly default in some sort of severe economic shock? You can’t just wait out the downturn until those notes recover. Those notes are gone for good. And the other notes can’t make up that difference. However unlikely that scenario is, it still makes me nervous.
Lending Club padded its stats
Finally, this Bloomberg Article and the revelation that Lending Club padded its stats for to impress Wall Street doesn’t help. It looks like this behavior may have been isolated and it doesn’t look like it negatively affected any of Lending Club’s members. But I’d be lying if press like that didn’t factor into our decision to pull out of the club.
The bottom line
Lending Club was a fun little experiment with a new kind of investment vehicle, but it isn’t for us. We haven’t lost money, but we’re winding our account down. We value liquidity in our taxable accounts. And if we’re going to take on extra risk with our money, we want the opportunity for much larger gains.
What are your thoughts on Lending Club and peer to peer lending?
Please do your own research before investing. I am not a financial expert and these are my opinions.
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