The Personal Finance Playbook

Editors Note: No Tuesday post this week.  I’m hosting the Money Hacks Carnival on Wednesday, so I had to do some preliminary type stuff for that and ran out of time.  My Thursday post is going to be on Master Limited Partnerships, so please stop by for that, and of course, come by to check out the posts in the carnival.

I’m calling this a preview because I haven’t actually made a loan through lending club yet.  I’ve opened an account, read pretty much every page of information on their site, and now I’m waiting until a debit shows up in my account before I can start funding my account and making loans.  I’m also counting this as Mondays post even though I’m going to publish it on Sunday night.

In case you haven’t heard of Lending Club, it’s an internet peer to peer lending company.  You could use it to either invest in promissory notes, that is, the paper that says you have the right to receive payment on a particular loan.  Or, you could use it as a borrower to fund a purchase of personal property or your expenses.  My interest in Lending Club is as an investor, but I think it would be a reasonable resource for taking out a loan as a borrower, too, but only if it’s the lowest rate you can get for a particular purchase.  For instance, I have a friend who recently made a purchase of several thousand dollars on a 0% interest rate credit card.  If he doesn’t have that card paid off by the time the 0% is over, he can expect to pay 15-30% on that card (that’s one of the ways they get you).  In that case, if he can borrow money from Lending Club (or any other Peer to Peer lending company – Lending Club just happens to be the one I’m familiar with) at 10% that might be a prudent course of action.  He would want to check with his local bank or credit union as well, and go after the lowest rate available, of course.

As an investor, peer to peer lending allows you to act as a lender.  Each loan requires you to invest a minimum of $25.  So someone borrowing $1000 might have gotten the money from 40 different lenders.  Lending club takes the money, charges the borrower a fee, and gives the bundle to the borrower.  Lending Club services the loan, meaning that payments are made to them, and they make contact if there is a delinquent payment or default.  This is good for all parties.  The borrower doesn’t have to worry about making 40 small payments to all of his creditors, and you don’t have to try to hound the borrower for payment if he’s late.

What’s cool about this as an investor, besides the fact that it allows you to invest in a different medium, is that your returns tend to be significantly higher than if you were investing in fixed income investments like cds, treasury bills, or even most corporate notes.  This makes sense, because there is increased risk.  I think it makes sense to look at how severe that risk tends to be, and whether it offers enough upside to outweigh that risk.

The risk, put simply, is that the borrower won’t repay you on the loan.  There are two types of debt, secured and unsecured.  Secured debt is tied to a particular asset.  That asset stands as collateral for your debt.  For instance, if you buy a car on credit, they secure the loan with a provision in your agreement that says that if you fail to pay on the debt, the lender can take the car from you and sell it in an attempt to recoup what you owe.  Unsecured debt isn’t tied to an asset.  Of course, if you don’t pay, someone could sue you for what you owe and a judgment could be recorded against you.  That judgment could be a lien against assets you own in the jurisdiction where the judgment was recorded.

I’m still getting the hang of the info on Lending Club, but looking through some of the notes you can see the reason the person wants the loan, a summarized view of their credit history, their credit score, etc.  You act as the underwriter and decide whether a person is credit worthy.  This creates a risk, because you aren’t an underwriter.  Of course, the people with better credit can borrow money at lower rates than the people with lesser credit ratings and histories.

Lending Club puts borrowers into 7 categories: A, B, C, D, E, F and G, with A being the most credit worthy borrowers and G being the least.  They also offer stats on default.  These only go back to June of 2007.  It’s a small sample size, but since that time, 0% of borrowers with an A rating have defaulted, 3.7% of B loans have defaulted, 4.2% of C loans have defaulted, 7.5% of D loans have defaulted, 9.6% of E loans have defaulted, and about 23% of F and G loans have defaulted.

I’m planning on only investing in A and B loans.  Of course, you get paid for taking on a larger amount of risk if you’re willing to step into the riskier loans (the average G loan pays 19.47% vs an average of 8.4% for A or 11.58% for B).  Let’s take a look at a hypothetical.  Let’s say I want to invest $1,000 in loans, spread out over 40 loans ($25 each) for diversity.  Let’s say my average return is 10%, for the sake of simplicity.  Let’s say that exactly 5%, and only 5% default without making a single payment.  Let’s also assume that rather than the 5% being spread out over multiple loans after some payments have been made, exactly 5% of the loans will default after making no payments.  5% of 40 loans would be 2 loans ($50) plus the interest that would have been earned that year ($5).  That means you would have had $950 working for you at 10% for a $95 return.  Your $1000 under these circumstances would have grown to $1045, or a 4.5% return.  4.5% is nothing to write home about, but it’s still pretty good, and we assumed a higher default rate than the historical average of C loans (4.2%), which tend to return, on average 13.16%.  So we over estimated our default rate (hopefully) and under estimated our return based on that default rate, and still came out making 4.5%, which is much higher than the current 1.9% rate a CD will pay you.

Like I said, I’m planning on focusing mostly on a portfolio of A and B loans, and I’m going to spread my money out over as many loans as I can.  Hopefully this will be a worthwhile investment.  I’ll keep everyone updated on late payments and defaults and we’ll try to figure out our actual return at the end of the year.  I’m probably going to fund my account this week with either 1 or 2 thousand to get started, then make the minimum loans in $25 increments.  You can get $25 free to invest by joining using this link.  I get a referral if you use it as well.  Once you’ve joined, you’ll be able to refer people and give them the free $25, too.  Assuming it works (I didn’t get referred), the site says you can immediately lend it without funding your account any further.  So that’s pretty cool.  If you decide to try it, let me know how it goes, what you’re returns are like, defaults are like, etc.  Good luck and thanks for reading.

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This entry was posted on Sunday, July 5th, 2009 at 3:41 pm and is filed under Reviews. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.