How peer-to-peer lending works and what annualized return should you expect.
In this episode you’ll learn:
- How peer-to-peer lending has changed from the early days.
- What are member payment dependent notes.
- What is non recourse debt.
- What has been the historical and estimated returns from peer-to-peer lending.
- How peer-to-peer lending can serve as a bond substitute..
- An overview of lending on property within a self directed individual retirement account.
What Can You Earn With Peer-to-peer Lending?
In 2006, I decided to become a personal banker.
I opened an account on a relatively new site called Prosper and funded it with a few thousand dollars. Then I went about finding people to whom I could lend.
This was in the early days of peer-to-peer lending when you were literally lending to peers.
People who wanted to borrow wrote narratives on Prosper about themselves and what they were going to do with the money. They uploaded photos so you could look them in the eye (at least digitally) to see if they seemed like the kind of person who would pay you back.
Prosper also performed some of their own due diligence such as credit checks and income verification. They then ranked the borrowers by their credit worthiness.
Borrowing rates ranged from 8% to well over 20% with terms of three to five years.
For example, I participated in a loan to Kori a 21-year old baton teacher with no credit history who wanted to buy a car to get to and from the baton lessons she taught at local schools. She borrowed $5,000 at a 23% annual interest rate.
Most of my loans were in the $25 to $75 range as Prosper combined my contributions with those of other lenders in order to fund the borrower’s requested loan amount.
Prosper was fascinating because the company opened up its data so you could see the returns everyone was achieving on their loan portfolios. You could also see who loaned the most. There were several individuals with loan books of $400,000 or more.
Turmoil In The Peer-to-peer Lending Space
Then the Great Recession hit. The unemployment rate rose and default rates on Prosper soared including on a number of my loans.
In 2008, the Federal Government shut Prosper down for illegally selling unregistered securities.
It turns out aggregating funds from willing peer-to-peer lenders is considered an unregistered security sale.
In the U.S., companies can only sell unregistered securities to “accredited investors”, who are individuals with a net worth of at least one million dollars or annual income exceeding $200,000.
A class action suit ensued, which Prosper ultimately settled, and a few weeks ago I received a final check from Prosper as part of the settlement for $16.83.
The good news is Kori, the baton teacher, paid me back, although in retrospect a 23% interest rate on a car loan seems usurious.
Other borrowers defaulted, and my annualized return over the life of my loan portfolio after taking into account defaults ended up being around 2% annualized.
Peer-to-peer Lending Reinvented
Surprisingly, peer-to-peer lending sites didn’t go away.
Prosper reorganized its business operations and it—along with its largest competitor Lending Club—still facilitate peer-to-peer loans.
Only now investors don’t actually make loans directly. Instead, they invest in what Lending Club describes as “member payment dependent notes.”
Every borrower has a security created on their behalf. Investors buy the security. The borrower gets the proceeds, and the investors’ return on the security is based on the borrower’s performance in making interest and principal payments.
The investors no longer get to see to whom they are lending. There is no name or photo attached to the security. Just some basic credit and financial information, such as a credit score, gross income, debt-to-income statistics, employment status, home ownership status and other information related to the borrower’s credit history.
Besides Prosper and Lending Club, there are peer-to-peer lending sites that raise loan proceeds from accredited investors.
An example is Upstart, who not only screens and ranks loans based on credit scores, but also looks at schools attended, grade point average and standardized test scores.
What can investors expect to earn with a diversified portfolio of loans (i.e. member payment dependent notes)?
Fortunately, some of the peer-to-peer lending sites are still transparent with their data.
Lending Club has the longest history and most complete data set.
Average loan rates on their site were 13.1% last quarter with a range of 5.3% to 29%.
Lending Club estimates investor returns after default will be 5.2% annualized for those lending to the highest rated borrowers to 9.1% annualized for those lending to the poorest credits, whose loan rates average 23.3%.
Those expectations are based on both historical results as well as current loans whose payment behavior is expected to follow the historical pattern.
I prefer to look at the investor experience for loans whose terms are completed. That way there isn’t any forward looking projections.
Not surprisingly, the return experience differs for loans issued during the Great Recession versus those funded afterwards.
The average annualized rate of return for Lending Club loans issued during 2007 and 2008 was 2%, similar to my early experience at Prosper.
For loans issued between 2009 and 2011, the average annualized return has been 6.6%.
The highest rated borrowers (those ranked “A”) on Lending Club have generated the most consistent return, both in and out of the recession with an average annualized return of 4.6% to 5.3%.
For loans issued during the recession, the lowest rated borrowers performed the worst with an average annualized return of -2.3%.
During non-recessionary periods, the best performing category were borrowers rated E by Lending Club with an average annualized return of 8.2%.
A Bond Substitute
A conservative investor who is lending to the more credit worthy borrowers could potentially earn between 4.5% and 6.0% annualized after adjusting for defaults.
That is higher than the 2% to 3% yield for the overall U.S. bond market with a lot less volatility since peer-to-peer loan values don’t fluctuate in value as interest rates change.