Peer to Peer Lending – Pros and Cons

We will examine the pros and cons of investing on peer to peer lending platforms like Prosper and Lending Club. I will use personal experiences to give you practical insights and comparisons to other forms of investments readily available to investor.

In 2014 alone, Peer to Peer lending (P2P) platforms in United States issued approximately $5.5 Billion in loans – that is about half a million borrowers and several million lenders.

A very quick primer about how it works – there are these websites called ‘marketplace lenders’ – Lending Club and Prosper are the biggest ones in the market today. Let’s say John Doe needs $10,000 to make home improvements. He registers with one of these marketplaces, fills in his details (income, location, occupation etc – mostly standard underwriting parameters used by banks).

How P2P worksBased on the underwriting done by the marketplace, John is assigned a loan category (For example, A B C D E) and an interest rate (corresponding to the riskiness of the loan depending mostly depending on the category). Once John accepts the terms, the loan is available on the website for investors like me to invest. Usual minimum is $25, I do not think there is a maximum (I have personally done till $400 per borrower). At $25, it will take 400 investors to make $10,000 to lend to John.

Once John starts to make monthly payments, investors like me start to get our money (and interest) back.

My analysis below has three sections: understanding where this new asset class (sub class) fits in the traditional portfolio, pros of P2P lending, and cons of P2P lending.

  1. P2P Lending is a US bonds categoryUnderstanding the new ‘asset class’ that Prosper and Lending Club have created
    Broadly speaking, there are the following six asset classes in the stock market – US stocks (Large cap, Mid cap, Small cap), Foreign stocks (Developed, Developing), US bonds (Government, Corporate), Foreign bonds (Government, Corporate), Alternatives (Real Estate, Commodities, Currency), and Cash.

Out of these six asset classes, US bonds (Corporate) is the closest to P2P lending. Essentially ‘Peer to Peer loans’ are US bonds (Personal) – money lent to individuals.

2. PEER TO PEER LENDING PROS: Less correlation with other asset class, relatively less risk of losing a large portion of principal, and it is one of the best ‘parking’ places.

2.1 Less correlation with other asset class – Large cap domestic stocks have a relatively high degree of correlation with the small cap domestic stock. Simply stated, they tend to move together. In other words, it is common to see the small cap stocks going up when the large cap stocks are going up (and vice – versa about going down).

This new asset class (sub – class) created by Prosper and Lending Club appears to be not highly correlated with any other class. So this is good – diversification.

2.2 Relatively less risk of losing a large portion of principal: No investment ever is risk free but these peer to peer loans seem to have a low risk of losing a large portion of principal. The data published by one of the marketplaces (either Prosper or Lending Club) indicated that the worse year in the last 6 years was when investors lost 4% of the principal.

2.3 One of the best ‘parking’ places: this is my personal favorite and the main reason why I ended up investing in peer to peer lending (I am an investor on Prosper as well as Lending Club). Let us say you would like to park some monies in an investment that pays decent returns in the ‘medium term’ and has a high chance of returning the principal, P2P is the place to be.

2.4 Automation: Once an investor has set the investment criteria (peer to peer loan criteria to search loans and auto-invest), the system automatically invests in the loans with those characteristics as and when they come available on the platform, no manual interaction with the investor is required anymore. Changing the characteristics of the ‘desired’ loans (going forward) is also very convenient on Prosper as well as Lending Club.

Pros and Cons3. PEER TO PEER LENDING CONS: higher tax, lack of liquidity, no leverage, additional and ambiguous paperwork, not enough historical data, scarce customer service

3.1 Higher tax: Income from peer to peer lending is counted as ordinary income and will be taxed at the marginal tax rate; which is 28% for someone making $100,000 (significantly higher than the capital gains tax rate).

To make the matters worse for investors, investors cannot even deduct the losses!

3.2 Lack of liquidity: Although most major platforms (including Prosper and Lending Club) have come up with some form of a secondary market; in my opinion an urgent need for liquidity will make you sell the loans at 2 – 2.5% discount to their fair market value.

3.3 No leverage: In stock market as well as real estate, you can use leverage to enhance your returns. In peer to peer lending, you are always buying on cash.

3.4 Additional and ambiguous paperwork: Neither the marketplaces nor the IRS are completely clear as to the way the tax documentation will be issued by the marketplaces and entered by the taxpayers. Different platforms issue different format tax documentation that different investors are entering differently on their tax returns.

3.5 Not enough historical data: All of peer to peer lending in United States is less than 10 years old, and the current version of it is only about 6 years old. (The original version that started in 2006 had to be revamped in 2008 – 09 due to regulatory scrutiny and heavy losses due to poor underwriting procedures). Essentially, we only have 6 years of data on historical defaults and returns.

3.6 Scarce customer service: Unlike a brokerage firm where you can just pick up the phone and ask a customer representative about your account, such luxury isn’t available in peer to peer lending. You are free to send them a message and you are lucky if you get a satisfactory response. I am active on Prosper as well as Lending Club – my investment on Lending Club is mainly experimental and my investments on Prosper is where I actively invest/ track details. The first time when I emailed Prosper customer service, it took me nearly a month to find someone smart to help. From then on, the responses from Prosper have been somewhat adequate.

3.7 Idle funds: When I make my annual IRA contributions of $5,500, I am able to buy a well diversified ETF or two and invest all of that money in 1-2 days; but with peer to peer lending since your money needs to be spread among hundreds of loans, it takes longer. It will depend on the amount of money, the amount of money you are investing per loan, and your settings to choose peer to peer loans; but as a rough estimate, it takes anywhere from 1 week to 3 weeks for the entire money to be invested in peer to peer loans.

3.8 Institutional investors: What started as peer to peer lending has quickly become an institutional play too, and many a times there are institutional investors who would simply invest the entire $10,000 that John Doe asked for, leaving nothing for the actual peers to invest. It is suspected by retail investors like me that the peer to peer loans with best returns for a given risk are going away to investors.

3.9 New API services: API stands for Application Programming Interface. Simply put, professionals have developed these pieces of code that can get a retail investor quicker access to ‘peer to peer loan with desired characteristics’  quicker than if you were just registered with the marketplace. And these API providers do boast of higher returns than investors achieve via investing directly through the peer to peer lending marketplace. They come at a cost, I have not tried one yet.

Whenever someone tells me that ‘peer to peer lending is unsecured and hence more risky’, I always tell them ‘banks have made money on credit cards forever’ – credit cards are also unsecured lending to individuals. I do not have to go and study the annual report of a bank to see how much money their credit card business makes; it is clear to me that banks make a hell lot of money on credit cards because of all the sign on bonuses and cash back rewards they give to customers in order to retain them.

MY TAKE OVERALL

Peer to Peer lending (and both Prosper and Lending Club) is here to stay. This industry will only grow with time. The growth will be enhanced if the tax related ambiguities are sorted out. I have not been a borrower but I think they are certainly getting a better rate as compared to credit card debt.

For a young sophisticated investor though, who do not have too much space for fixed income instruments (like bonds) in their portfolio, P2P loans are a good tool only for ‘parking’ purposes, I do not view this as a long term core portfolio holding.

The more risk averse investors, whose target is to more than 15% of their investment portfolio in bonds, should definitely consider this new asset class as an addition to their portfolio (replacing some of their bond holdings).

Got something to ask? Something to add? Something to disagree? Please leave a comment….  let us discuss.

Lending Club_$400 bonus_ P2P .png

Lending Club_$400 bonus_ P2P .png

Update: 1/28/2016 Lending Club is offering $400 to everyone I invite to join (disclaimer – I do not get anything).

I personally like Prosper a little more than I like Lending Club but many people start with Lending Club – it has more loans to pick from and has a better website.

Update (2/17): It looks like the $400 bonus has now become $750 – wow!

Update (5/2): It looks like the bonus has now become $1,000 – wow or not?

Well over the last 3 months, the cash offer has gone up from 450 to 1,000 now; it looks like the company is having a tough time getting investors. (I am also taking into account that my annualized adjusted net return on Lending Club are just about 3% so I am guessing other investors are making similar returns if not less and pulling out).

 

Still if you would like to get this $1,000, subscribe to this blog using your email, leave a comment below and I can invite you.

(Do not join just for the bonus – if you were planning to join anyway, then this bonus is an added incentive).

48 thoughts on “Peer to Peer Lending – Pros and Cons

    • Vj,

      Yes, I am very familiar with Realty Shares website (www.realtyshares.com).

      I have been an investor on Realty Shares website for about a year now, have made about 40 investments, 32 of which are still open (others have either reached their term or have been paid off early).

      Till now, I ‘think’ I am getting the returns I was promised. Let me explain why I say I ‘think’ – it is not really easy to track every investment since every investment is really unique in terms of their payment terms and schedule. Moreover their website does not yet do a great job of investor reporting. But from the samples I have tested, I am getting the returns I was promised.

      The biggest risk in my opinion though is the ‘platform risk’. You as an investor are relying totally on them for all the due diligence. I have no reasons to believe that they are a fraud but then nobody had reasons to believe that Bernie Madoff was a fraud either. So, I would advise you to be very cautious before investing large amounts of money.

      The second biggest risk in my opinion is the ‘market risk’. This is a very legitimate risk (unlike the fraud risk that I mentioned before). This is the risk that is promising you high returns – a typical debt investment on Realty Shares returns 10% and equity investments are projected to return around 15%.

      So these are risky investments, if the real estate market crashes like it did in 2008 – 09, I am likely to lose all my equity investments and perhaps even a portion of my debt investments.

      I would be happy to answer any more questions that you have…

      By the way, I also invest on http://www.fundrise.com

  1. Banks make money on credit cards, but have clear advantages over you or I doing peer to peer lending.
    1) the interest collected on credit cards is greater.
    2) in addition to interest the bank collects approx. 3% vender fees per transaction.
    3) The bank can multiply the money it lends through fractional reserve banking.
    4) The bank has more teeth to extract payment primarily through the threat of ruining the borrower’s credit
    5) If things go to hell in a hand basket, the bank can petition the government for a bail out
    6) the bank can collect considerable additional money through fees and penalties
    So the banks can afford to write off considerable losses, and still come out ahead

    • Brian, I mostly agree with you.

      1 – I agree. And that is one of the reasons many borrowers prefer p2p loans over credit card balances
      2 – Agreed. And if I could issue credit cards, I would 🙂
      3 – If you are saying that the bank accepts deposits and then lends out that money, then I agree that we investors do not have access to deposits
      4 – Borrower’s credit also gets ruined on the p2p platforms
      5 – Lol, that is so true
      6 – There are some fees and penalties on p2p platforms too

      Overall I agree that banks are likely to still come out ahead but I do not think the difference will be 2x or 3x. Moreover, being a p2p lender is such a viable option for common investors (not everyone can own a bank).

  2. Hi,

    Have you been involved with any of the real estate marketplaces/crowdfunding platforms? Diving deeper into that asset class as a follow-up post could be interesting to your readers given the industry’s growth. I am particularly talking about companies like Realtyshares, Realtymogul, Fundrise, and PeerStreet. Most of these loans are secured by the underlying real estate versus consumer debt which is unsecured.

    Regards,

    Jessica

    • Jessica,

      Please see my response to Vj on Jan 1, 2016 (another reader who commented on this p2p lending post).

      I invest on RealtyShares as well as Fundrise.

      You are right – diving deeper into the real estate marketplace asset class will be interesting to the readers, specially given it’s growth.

      Would you like to write a guest post? It will be a welcome change to hear from an industry insider.

      Bobby

      • Your points about “market risk” are very valid. 10% – 15% seems very high.
        Probably while the real estate market was recovering that was a reality
        but it seems like nowadays, this could be more risky.

        I heard that Real Estate values in Los Angeles have flattened out.
        A friend sold his house, it took 6 months and he had to lower the price.

        • “When the markets were recovering” – Only in retrospect, one can conclude that markets were recovering. Imagine if they did not recover completely and dipped 10-20% once again – then you would not say that the markets were recovering. You would say ‘Markets were still going through a tough time’.

          No one knows what will happen tomorrow (in near future).

          Like you rightly said 10% – 15% is high and represents the underlying risk.

          Just this past weekend – someone relatively ‘not knowledgeable’ about finances asked me ‘Why do all these borrowers on RealtyShares do not go to a traditional bank and borrow at 5% instead of paying you 15%? I told him ‘The banks will not lend them money’. And even he understood that ‘Banks will not lend them money because these transactions are risky’.

          Hope that helps, please feel free to ask/ discuss more, I write because you read 🙂

          • Yes, I am familiar with it.

            The ‘sell after one year’ and buy ‘new magic stocks’ is the same as portfolio re-balancing and should ideally lead to ‘buy low and sell high’ scenario.

            I have nothing for/ against the magic formula investing – I would tend to believe that “picking a good asset allocation, investing religiously over a long period of time in low-cost ETFs, and re-balancing periodically” beats most of the magic created by any model.

      • Interesting that there is a quote from Dr. Michael Burry (Big Short Mortgage Crisis Winner)
        on Peer Street website… he is personally endorsing this platform?

        • You are right – his name is listed as an adviser/ investor. So he is kind of endorsing the platform.

          Let us wait to see if Jessica can further clarify Dr Michael Burry’s role on Peerstreet?

          • I got an email back from Peerstreet today…

            “We are very lucky to have Dr. Michael Burry as an investor in PeerStreet”

  3. So, would you folks consider p2p to be less risky than real-estate ‘crowd funding’ vehicles? Fundrise for example lets ‘non-accredited’ investors in their eREIT, vs. individual deals are reserved for accredited investors.

    • I would not attach too much importance to ‘non-accredited’ investors v/s accredited investors. Those differences are primarily due to regulatory requirements and not directly related to the inherent risk in the investments.

      Now coming to the main question: Whether p2p to be less risky than real-estate ‘crowd funding’ vehicles?

      Short answer – Yes.

      Long answer:

      1. Secured v/s unsecured: Real estate deals are secured by the property while p2p is unsecured lending. So from that perspective, real estate is less risky. You can force a sale of the property in case of default.

      2. Real estate deals can be of many ‘forms’ – the ones with ‘personal guarantee‘ of the borrower are less risky than a corresponding note on a p2p platform (this real estate deal is secured by the property and also backed by personal credit of the borrower – we call them sponsor in real estate crowdfunding world)

      3. p2p has a longer track record than real estate crowdfunding – the p2p platforms have been around for 5-7 years while the real estate just started picking up steam, 1-2 years back. Lack of historical data goes against real estate crowdfunding.

      4. Audit/ transparency – The largest p2p platforms come under the purview of SEC, so they do file regular reports and prospectus with the SEC. It does give me a lot of comfort when I compare it to the real estate crowdfunding platform – where it is 10 employees and a website. I am relying totally on them – I call this platform risk.

      As I have said before – I have a lot of respect for all these platforms – I am myself making money because of them. I have no reason whatsoever to believe that any of these platforms is corrupt but then I always keep Madoff in mind.

      5. Market risk – this is specially true for the equity investments in real estate. Mr. X is buying a property for $500,000. He puts in $50,000 equity, 10 others put in $5,000 each, and you take the remaining $400,000 as debt. He was hoping to sell the property for $600,000 there by making everyone some money .But the real estate market tanked – property prices lose 25% value. Now the property is worth $375,000.

      In total, $125,000 has been lost. Who lost it? Mr. X lost all his 50k, 10 investors lost all their 50k, and the debt holder lost 25k.

      Market risk affects the p2p returns too but with all the data I could collect about p2p, investors never lost more than 4% of the principal. (Again, all the data I could collect might not be all the data that exists, so if you can prove me wrong, I would be happy to learn from you).

      6. Diversification – my analysis says one needs about 400 notes to be well diversified in p2p and at least 20 properties in real estate crowdfunding. Given that a p2p note can be as low as $25, you need only $10,000 to diversify while you would need a lot more in real estate.

      7. Art – picking up real estate crowdfunding deals is an art – I look at multiple parameters and then make a decision. P2P is more automated – I have automatic criteria that picks up ‘certain’ loans as and when they appear – I have multiple loans originate every single day. I have thousands of notes in my portfolio.

      I practice what I preach. I think like the way I write here – I invest my own money using my principles. Still, each situation is unique and what works for me might or might not work for you.

  4. Just came upon your great article when I am doing research on P2P lending. Thanks for sharing your experience and thoughts. I subscribe to your blog already.

    PS: is the $400 offer invitation still valid, if so can you sent an invitation to my email, thank you very much

    • $750 offer emailed.

      Please subscribe using your email ID – top right of this post. 51 new post ideas are in pipeline – I intend to write only 2-3 posts per month so those are the only times you will hear from me.

  5. Hi Bobby,

    Thanks for the P2P info and the comparison to Real Estate share investing. I just subscribed! Please send the link for the Lending Club offer. I am ready to give it a try!

    Thanks,
    Debra

  6. I am interested in starting on lending club. Thanks for the information. Is there a minimum investment amount to get the bonus? Please send me a link for the $750 lending club bonus.

    Thanks,
    Tarang

    • $750 bonus is for investment amount of $25,000. Usually it is a tiered promotion, so you should get some bonus for lower amounts too.

      I do not remember all the details but I have sent you the link. See the terms and conditions for minimum investment amount details.

      Please be aware that I do not receive any compensation from any of the things I talk about on my blog (this can change in future without notice).

  7. Hi Bobby,

    Another good post. Is there any reason why you preferred Prosper over Lending Club? If both are comparable it would be a good idea to diversify in both the platforms just in case one of them goes bankrupt.

    Would you share your invite to me as well?

    Thanks

    • Hi Cartman – thanks.

      I preferred Prosper over LC primarily because historical returns on Prosper were higher, hence I was hoping to make higher returns on Prosper. And in reality too, I am making a little bit more than LC on prosper but the returns are not as high as they projected them to be.

      You are right about diversifying the platform risk but my p2p investments even though 6-figures are only a small portion of my overall portfolio.

      A friend of mine from NSRInvest did the following graphic for me. I have not personally verified but it suggests that you are more protected in Prosper in case of ‘bankruptcy’

      Emailed you the invite.

  8. Hey, great post man. I do love your blog!

    A couple questions:

    1. Do you know twino (www.twino.eu)? I just started to invest there, but have no reliable historical data on the system.
    2. Can Europeans also invest through LC and Prosper? If so, please send the the invite. 🙂

    Thanks

    • Hi Arthur,

      Thank you.

      1 – I do not know Twino

      2 – I also do not know for sure whether non-Americans can invest through LC/ Prosper – I do know that non-Americans can invest in stocks directly.

      My best bet would be to try opening an account at Prosper/ LC and if they let you do it, then you can do it. In these scenarios, the onus usually lies on the financial institution/ broker and not you as an investor. They are the ones who are more heavily regulated. I will email you the invite

  9. Hi, Bobby. Did you hear about Yieldstreet or Groundfloor? Groundfloor seems to be just another real estate investment site, though. But what caught my eye about Yieldstreet, is that they invest in different litigation cases. Even in the event of another downturn of the economy people will still sue the other people, so that seems to be less dependent on economy conditions than everything else, including real estate. Of course they have a bit high entry requirement, $5000 minimum.
    Also I am a bit torn between Prosper and LendingClub myself, so thank you very much for all the info you posted here.
    Though I’ve found this website, http://www.credio.com/, it allows you to compare different lending companies, but they do not have big list of them.
    Please, send me LendingClub link as well.

    Thanks again.
    Max

    • Hey Max,

      I have heard about both Groundfloor and Yieldstreet. I have not invested through any of them yet.

      Groundfloor is like some others in the market – the key differentiation in that space will come when ‘some loans start to default’. Right now the industry is new and the real estate market has been doing well, hence we do not know how ‘reliable’ their underwriting standards are – for any of them. Once some loans start to default, then investors will flock to the platforms that deliver what was promised.

      Yieldstreet is an interesting concept – although this has been there forever ‘purchasing the receivables at a discount’ or ‘purchasing the proceeds of a lawsuit’; this is the first time it has been made available to investors through such a website.

      In cases where the lawsuit has been settled, there is ‘credit risk’ – that the counter party might not be able to pay. In cases where the lawsuit has not been settled, additional risk arises because investors do not know result of the lawsuit.

      Sent you the Lending Club link.

  10. Hi – Just got to know about your blog. Already loving it. Saw this post and was wondering if this offer still stands. If yes, please send me the invite.

    Thanks,
    – V

  11. Hey Man,

    Great post. Really got me interested and probably will invest (Especially as I heard about that bonus) which if you would be so kind can you send to me? 🙂

    • Thank you.

      I have stopped to further invest in the real estate sector through these marketplace / crowd funding sites. Primary reasons being:

      1. Too much platform risk – you ‘trust’ the platform/ website to do all the research

      2. These are really risky investments – one market downturn and one might easily lose 50 – 75% of the principal.

      3. Bad reporting – in order to somewhat diversify you would need to have at least 15-20 investments (I had more than 50 at one time), and just keeping track of all the performance is a pain.

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