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).
Based 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.
- Understanding 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.
3. 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.
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).