Back when I was beginning to ponder the seemingly radical concept of “making my money work for me”, I became intrigued by the earning potential of peer-to-peer lending. The idea behind peer-to-peer lending (or “P2PL” in annoying jargonish) is that “marketplaces” such as Lending Club or Prosper facilitate the setting up of loans between people with a little bit of extra cash and folks who would like to borrow it. The marketplace vets the borrowers, ranks them by creditworthiness, documents the loans, and acts on the investors’ behalf in chasing down delinquents. For all of this, the marketplace gets paid a small portion of the loan proceeds – in the instance of Lending Club, that fee is generally 1% of all payments (principal and interest) actually received by the investors.* The elevator pitch of P2PL is that it is a win-win for all involved — individual investors can get in on all of the riches of loan sharking without any of the hassle, and borrowers can get loans without worrying about all of those pesky requirements of real banks.
Peer-to-peer lending is a favorite topic of financial independence bloggers, some of whom have reported very high earnings (>10%/yr in at least one case). Since I am a major fan of superior returns and on occasion fail to give proper consideration before following the thunder of loudly successful herds, about a year ago I decided to put a little of my own money to work with Lending Club, the biggest and most well-known of the P2PL marketplaces.
Now, eleven months later, I can report that Lending Club has proven to be a subpar investment for me. Pretty crappy in fact. (My wife calls it “that terrible, no-good, poopfest of an investment”). Now, generally I like to look good in the public sphere. It’s not that fun to talk about all my screw-ups and bad ideas. But given all the positive yapping going around the blogosphere about peer-to-peer lending, I thought it might be helpful to provide the details of at least one real-life example that hasn’t panned out.
I have a spreadsheet with all the the principal outlays, interest payments, late payments, charge offs, etc. But the point of this story would be lost if I tried to tell it in spreadsheets. Or at least not well communicated. So I’m going to just relay the facts in my own, semi-numeric, semi-literate, sort of way.
Here’s the backstory. I opened a Lending Club account in August of 2014 with an initial deposit of $2500. I chose to let Lending Club allocate my cash to loans via the Automated Investing function (I selected the proportional allocation across borrower risk grades and Lending Club’s algorithm then selected the specific loans for me). My risk allocation has shifted slightly over time, but for most of the past year has been close to 20% in A loans (least risky), 45% in B, 22% in C, 7% in D, 4% in E, 0% in F, 0% in G (most risky). Under the parameters that I set up, no more than $25 of my cash can be allocated to the same loan (i.e., my initial $2500 was spread across 100 loans of $25 each). I also initially elected to have all interest and principal payments reinvested into new loans.
The first few months were basically fine. Because of my self-imposed $25 limitation on credit exposure, it took several weeks for enough loans to become available for my $2500 to be fully invested (which meant that some of my $2500 was locked up with zero return for a while – this would be a bigger deal if my initial investment had been larger). Other than the slow start, I had no complaints about the first few months – the principal and interest payments rolled in, Lending Club reinvested the payments as directed, and all was fine.
But then I started seeing indications that some borrowers weren’t interested in repaying their loans. At all. As in, borrowers were defaulting after making only one or two payments. Although the most that I can lose if any one borrower decides not to repay their loan is $25, if multiple people decide not to repay …
In December one of my borrowers quit repaying their loan (after making one payment, resulting in a $0.58 return of principal to me and $24.42 of principal moving to the “late” category). By March, that $24.42 had graduated from “late” to “not gonna pay, never ever!” In April, another borrower decided to pocket my $25 with no pretense of ever repaying it, resulting in a further write-off of $24.48. In May, another $23.88 was gone. In June, another $22. Two more in July, one for $20.95 and the other for $21.55. To sum up, of my initial $2500 investment, a total of $115.28 in principal has now been completely written off, with no hope of recovery. Meaning, I won’t get that money back and I won’t make any interest on it either. There is also another $65.32 just sitting in the “late” column, waiting for the Lending Club folks to realize the futility and move it to the “I’m a sucker” column. And the bleeding won’t stop there. According to Lending Club’s own disclosures, I should expect the write-offs to accelerate further along the life of the loans (these are all 3 year loans, so I have two more years of this fun!).
But, you say, writeoffs are to be expected! That’s why the interest rates are so high – to compensate lenders for the risk of loss! Well, perhaps, in the aggregate, Lending Club’s interest rates “work” to balance overall risk tolerance of the majority of its investors and the statistical probabilities underlying the loans, but for me, for my investment, it really hasn’t worked. Not at all. I am currently making about $20 per month in interest. My monthly write-offs have been above $20 for each of the past four months.
For illustration, here is my account “summary” page, showing a snapshot of my investments/returns/chargeoffs.
Note that the 1.10% Adjusted Net Annualized Return incorporates Lending Club’s estimated loss rate for past-due loans based on what they claim to be historical loss rates for similar portfolios. However, thus far, I have not seen any loan that has ever taken a nap in the “late” column of my account statement go anywhere but straight to the “chargeoff” column. So, changing the assumptions underlying the “Adjusted Net Annualized Return” to 100% loss for all currently past-due loans changes my really crappy 1.10% annual return to .03%. Yes, that rounds to zero.
So I am very very far from the 5.6-8.6% returns that Lending Club says have been enjoyed by other accounts holding a similar array of loans, and a bazillion miles away from the 10% returns boasted by some financial bloggers. And since write-offs are supposed to accelerate even further as my loan portfolio ages, and since I am receiving less and less interest every month as principal is repaid or written off (I turned off the reinvesting option after it became clear how poorly this experiment is going), I would not be at all surprised to end up at a net loss by the end of the three years.
What’s the story? Why has this gone so badly for me? I have no idea. If I had picked the loans myself, I would assume that I just lack the ability to critically assess potential borrowers. However, I let Lending Club pick my loans with their super-duper algorithm. And at a max $25 investment per loan I’m exceptionally diversified across their borrowers. So I would have expected my returns to fall somewhere within or at least near the range of their reported averages. But I’m not even within spitting distance. So, I don’t know. Perhaps this is simply the law of averages working against me? Or maybe Lending Club just isn’t that good at assessing the riskiness of borrowers (two of my six defaulters were rated the relatively safe “B”, three “C” and only one “E”). Or, not to play the cynic, but could it be that borrowers increasingly understand that it’s relatively easy to get cash from Lending Club (because it isn’t a big bank with all those pesky high standards), and relatively easy to walk away from the repayment side of things? Thus far I haven’t seen any sign of Lending Club actually chasing anyone down, filing a lawsuit, recovering any portion of the defaulted amounts. Perhaps that will come in Year #2 – we’ll see.
In the meantime, I’d have to say that there are easier ways to make a negative return.* You could, for example, toast up some dollar bills and eat them for breakfast. Fiber! Or use them to make a papier mâché piñata for your 40th birthday party. Or make hundreds of greenback origami cranes and see how pretty they look floating downstream. All fun things to try, and all a super good use of your money.
*I call the money providers in the P2PL scheme “investors” rather than “lenders” because technically we are not lending our $$ directly to the borrower. Rather, we lend $$ to Lending Club pursuant to an unsecured loan, and Lending Club then makes a back-to-back loan to the borrower. This means that I can only seek repayment of my $$ from Lending Club, not from any individual borrower (i.e., I have no rights to sue or otherwise attempt to force payment by the ultimate borrower). It also means that I run double credit risk — Lending Club doesn’t have to pay me back if the underlying borrower defaults (i.e., LC’s repayment obligation to me is contingent on the borrower’s payments to them), and I also run the risk that Lending Club will run into ordinary-course business problems and default on their debt obligations (leaving me standing empty-handed as an unsecured creditor).