The following is a guest post by Peter Renton from Lend Academy. This advice won't work for me since Michigan doesn't allow peer to peer investing, but I'm sure some of you are interested in the topic.
Have you heard of peer to peer (p2p) lending but don’t know much about it? Maybe you read an article somewhere and thought it sounded interesting. But you probably wondered how to really get started. Then this post is for you.
First we should define what we mean by p2p lending. It is actually very simple. Sites like Lending Club and Prosper bring together people wanting to borrow money with people looking to invest money. This is all done online in a safe and secure way that benefits both parties. Borrowers get access to a loan at a better interest rate than they could likely get elsewhere and investors get a higher return on their money.
So how do people looking to invest get started? Well, you open an account at Lending Club or Prosper (the two companies available to U.S. investors) and start investing in loans. But before you do that you should learn about some p2p lending best practices. Below are five points that all investors should consider before they start investing.
1. Diversification
If you take nothing else from this article other than this point you will be well on your way to being a successful p2p lending investor. Both Lending Club and Prosper have a $25 minimum investment per loan. Don’t go above this minimum unless you are looking to invest $10,000 or more. I can’t emphasize this enough. You want to stay fully diversified so in the event of a borrower default the impact on your portfolio will be negligible.
Here is a quick example. Let’s assume you have $5,000 to invest. You could invest in 20 loans at $250 each or you could invest in 200 loans at $25 each. If you get an immediate default and you have only 20 loans you will be down 5%. With 200 loans you will only be down 0.5%.
2. Know your risk tolerance
Both Lending Club and Prosper assign a loan grade for every loan. At Lending Club it is grade A for the most creditworthy borrowers down to the grade G for the highest risk. At Prosper the range is AA to E and then HR being the highest risk borrowers.
Some investors take defaults personally. They loaned their money to a borrower in good faith and then the borrower decides to not pay. It is just not right. If you are one of those people then maybe you should stick with only the most creditworthy borrowers. You may still receive a default but default rates for these borrowers are typically less than 1% annually.
3. Do some research
One of the great parts of investing with p2p lending is the transparency. Both companies make their entire loan histories available for public scrutiny. Consequently, an entire eco-system has been developed and there are many free sites where you can analyze this data. For Lending Club investors there is Nickel Steamroller and Lendstats; for Prosper investors there is Prosper Stats or NumberWhale.
If the thought of choosing a strategy or sorting through hundreds of available loans feels overwhelming you can always copy me. I share my p2p lending investment strategy and I am happy for you to use this as a starting point.
4. Qualitative or quantitative investing
There are two kinds of p2p lending investors. Those who like to invest based on the data (I call these people quantitative investors) and those who like to read the loan descriptions to try and get a feel for each borrower (I call these people qualitative investors). Of course, you can do a combination of the two. For new investors it is useful to start as a qualitative investor and read some of the loan descriptions to help familiarize yourself with borrowers.
Having said that I am a purely quantitative investor. I am not recommending this as the best method but it is what works for me. Here is my reasoning. I have many accounts and I invest in 30-40 loans every week. If I were to spend even five minutes on every loan it would take me several hours every week to make my investments. Some people are happy to do that but for me I run filters on the available loans and invest in every single loan that meets my criteria.
5. Keep your expectations in check
Once you have made your first investment in loans you will see your returns displayed prominently every time you login to Lending Club and Prosper. You will likely be very excited about this number because it is more than you receive from your other investments. But I have some bad news. This return number will most likely reduce over time.
Unless you are very lucky and have a small portfolio you will see defaults impact your returns. Even if you have invested in only A-grade loans. The first defaults will hit the hardest. This is because new loans still have most of their balance outstanding and when a borrower defaults that outstanding balance is deducted from your account balance. Typically, returns reduce over time by several percentage points depending on your mix of loans. Just keep that in mind when you get excited about your returns.
Peer to peer lending is an investment that is growing in popularity all the time. Lending Club just recently crossed over $1 billion in new loans issued and both them and Prosper continue to experience rapid growth. In this low yield environment investors are looking for ways to boost their overall returns and p2p lending provides that opportunity. And if you keep these five points in mind you have an excellent chance of earning great returns, too.
Have you heard of peer to peer (p2p) lending but don’t know much about it? Maybe you read an article somewhere and thought it sounded interesting. But you probably wondered how to really get started. Then this post is for you.
First we should define what we mean by p2p lending. It is actually very simple. Sites like Lending Club and Prosper bring together people wanting to borrow money with people looking to invest money. This is all done online in a safe and secure way that benefits both parties. Borrowers get access to a loan at a better interest rate than they could likely get elsewhere and investors get a higher return on their money.
So how do people looking to invest get started? Well, you open an account at Lending Club or Prosper (the two companies available to U.S. investors) and start investing in loans. But before you do that you should learn about some p2p lending best practices. Below are five points that all investors should consider before they start investing.
1. Diversification
If you take nothing else from this article other than this point you will be well on your way to being a successful p2p lending investor. Both Lending Club and Prosper have a $25 minimum investment per loan. Don’t go above this minimum unless you are looking to invest $10,000 or more. I can’t emphasize this enough. You want to stay fully diversified so in the event of a borrower default the impact on your portfolio will be negligible.
Here is a quick example. Let’s assume you have $5,000 to invest. You could invest in 20 loans at $250 each or you could invest in 200 loans at $25 each. If you get an immediate default and you have only 20 loans you will be down 5%. With 200 loans you will only be down 0.5%.
2. Know your risk tolerance
Both Lending Club and Prosper assign a loan grade for every loan. At Lending Club it is grade A for the most creditworthy borrowers down to the grade G for the highest risk. At Prosper the range is AA to E and then HR being the highest risk borrowers.
Some investors take defaults personally. They loaned their money to a borrower in good faith and then the borrower decides to not pay. It is just not right. If you are one of those people then maybe you should stick with only the most creditworthy borrowers. You may still receive a default but default rates for these borrowers are typically less than 1% annually.
3. Do some research
One of the great parts of investing with p2p lending is the transparency. Both companies make their entire loan histories available for public scrutiny. Consequently, an entire eco-system has been developed and there are many free sites where you can analyze this data. For Lending Club investors there is Nickel Steamroller and Lendstats; for Prosper investors there is Prosper Stats or NumberWhale.
If the thought of choosing a strategy or sorting through hundreds of available loans feels overwhelming you can always copy me. I share my p2p lending investment strategy and I am happy for you to use this as a starting point.
4. Qualitative or quantitative investing
There are two kinds of p2p lending investors. Those who like to invest based on the data (I call these people quantitative investors) and those who like to read the loan descriptions to try and get a feel for each borrower (I call these people qualitative investors). Of course, you can do a combination of the two. For new investors it is useful to start as a qualitative investor and read some of the loan descriptions to help familiarize yourself with borrowers.
Having said that I am a purely quantitative investor. I am not recommending this as the best method but it is what works for me. Here is my reasoning. I have many accounts and I invest in 30-40 loans every week. If I were to spend even five minutes on every loan it would take me several hours every week to make my investments. Some people are happy to do that but for me I run filters on the available loans and invest in every single loan that meets my criteria.
5. Keep your expectations in check
Once you have made your first investment in loans you will see your returns displayed prominently every time you login to Lending Club and Prosper. You will likely be very excited about this number because it is more than you receive from your other investments. But I have some bad news. This return number will most likely reduce over time.
Unless you are very lucky and have a small portfolio you will see defaults impact your returns. Even if you have invested in only A-grade loans. The first defaults will hit the hardest. This is because new loans still have most of their balance outstanding and when a borrower defaults that outstanding balance is deducted from your account balance. Typically, returns reduce over time by several percentage points depending on your mix of loans. Just keep that in mind when you get excited about your returns.
Peer to peer lending is an investment that is growing in popularity all the time. Lending Club just recently crossed over $1 billion in new loans issued and both them and Prosper continue to experience rapid growth. In this low yield environment investors are looking for ways to boost their overall returns and p2p lending provides that opportunity. And if you keep these five points in mind you have an excellent chance of earning great returns, too.
This is definitely something I have been interested in. Maybe I will try it out in 2013 or 2014 after my girlfriend's student loans are hopefully gone.
Posted by: Lance@MoneyLife&More | November 28, 2012 at 09:18 AM
interesting article. How long are the loans? Do you favor a particular length Peter? Is it possible to sell loans on?
Posted by: Andrew | November 28, 2012 at 12:56 PM
Andrew, The loans are typically 3-year or 5-year, and my portfolio is roughly 2/3 3-year and 1/3 5-year. And yes there is a secondary market where you can sell loans which allows investors to liquidate loans before the term is done.
Posted by: Peter Renton | November 29, 2012 at 11:27 AM
Bummer - I didn't know that Michigan residents can't invest directly with P2P lenders like Lending Club.
I borrowed money from lending club just over a year ago when I needed a new furnace for my rental house. The process was extremely smooth and easy. My loan was funded within minutes.
I was looking forward to being a Lending Club investor soon but I guess will have to wait on Michigan to change the law.
Posted by: Rich@Money Wise Pastor | November 30, 2012 at 04:09 PM