Lending Club – Why I Chose Not To Invest In Peer-To-Peer Lending

by Mike Holman

In the blogosphere there seems to be a lot of excitement about peer-to-peer lending which is the ability to lend money to other individuals through companies such as Prosper and Lending Club. While I can understand how some investors will always be interested in a new investment product I don’t really understand the widespread excitement and interest level for this one.

Some of the things people should think about when considering P2P lending:

Diversification

Lending to one person is kind of like investing in a very small risky stock such as a junior mining company or a startup biotech company. You really don’t know much about that borrower and if something happens to them such as a medical emergency then your loan to them might be at risk. You can mitigate this risk by lending using a portfolio plan but I suggest that while this does reduce your risk, it doesn’t change the basic asset class which is still quite risky. A portfolio of p2p loans is like a mutual fund with numerous junior mining companies). You reduce the risk of any one company failing but aren’t protected against events that affect all junior mining companies ie falling metal prices.
One of the big risks that I would be concerned about is if interest rates go up. Presumably people who borrow on p2p are people who can’t get the loan from a bank at a normal rate – I would assume these people have already maxed out their credit or at a minimum have a lot of debt which makes them very vulnerable if interest rates increase.

Same as the old bank

Brip Blap wrote an interesting post on P2P which indicates that the lender “is the bank”. I have to disagree with this because I think Prosper or Lending Club is the bank. The only thing that really changes is that the p2p lender gets to choose who the borrower is which is not the case when you give money to a regular bank to get interest. Another issue I have is that Prosper and Lending Club seem to be spending a lot of money to get clients – advertising, free money giveaways. Where does this money come from? As far as cutting out the middle man – P2P institutions charge for the loans so I don’t really see how they are very much different from banks.

Statistics

Another concern I have is that I think the interest rates are too good to be true. If a borrower is willing to take my money for 10% then I know that they couldn’t get that same loan at a bank. This is problematic for two reasons –

  1. The banks are far better at analyzing debtor risk than you or I (too bad they couldn’t analyze subprime securitization loans) so if they don’t feel the person is worth the risk at 10% then you are not getting a deal – you are getting a high risk loan.
  2. If the person seems to have reasonable credit then they might have maxed out all their available credit which implies to me that their credit score is meaningless in that situation.

The fact that p2p has not been around very long also means that any default rates are probably understated. A loan can go into default at any time in the three year term so looking at default rates before three years is not going to be very accurate. Also – with the default rates do they do it by time periods? ie years? if not then any new loans will decrease the default rate dramatically.

Taxation

In the US, interest income is treated as regular income for taxation purposes. Dividends and capital gains are given preferential treatment and you will pay less than than on interest. You will be better off taxation wise to have all three of those investment types in a tax-sheltered account such as a 401(k) or ROTH account. If however you have investments in a taxable account then ideally it should not be fixed income such as bonds or P2P loans. Since P2P loans are not eligible for tax sheltered accounts then the extra taxes will reduce returns significantly.

Asset allocation

Asset allocation or the type of assets you invest in (ie stocks, bonds, cash) is a critical step in the investment process. Personally I have 25% of my investments in fixed income and 75% in equities (stocks). Regardless of the expected rate of return, P2P lending is considered fixed income and it should fit into your desired asset allocation.

Basic economics

If something is too good to be true then it probably isn’t. Currently you can get approximately 4% interest on guaranteed certificates or accounts. If you invest in P2P loans and have an expected return of 10% then that puts you in a much higher risk level and there is a reasonable chance that you could lose 10% or more (much like equities).

Bottom line

I have no plans to invest in p2p loans anytime soon because they don’t fit my investment plan. I do want to make it clear that I’m not suggesting that p2p loans should be avoided or that they are a bad thing. If you know what you are investing in and it fits your investment objectives then go ahead and lend away!

More peer-to-peer lending posts

Moolanomy questions if peer-to-peer lending is ready for the big time.
Cash Money Life answers Moolanomy in his post as to whether p2p lending is safe.

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{ 6 comments… read them below or add one }

1 Kyle

I personally choose not to lend on P2P networks either. P2P loans to individuals are likely to rise and fall with the overall economy: if the economy does well, people will be able to pay theri P2P loans off. If not, they won’t. But one thing is for sure: P2P loans are going to be the first thing people stop making payments on. Since the fortunes of any P2P portfolio are likely to follow the overall economy, why not just invest in stocks? You are likely to get no diversification benefit from this sort of fixed income investment.

2 Mr. Cheap

My prosper account has NOT prospered, so I’d say your instincts were right on this one Mike. As it is, I think the problem with P2P lending is just that the risk / reward tradeoff hasn’t been ironed out properly. As you say, in the early days its hard to properly evaluate the risk on a new investment vehicle. My feeling is that the current rates STRONGLY favour the borrower. Perhaps if the rates were reasonable, borrowers would just go to a bank (as you suggest).

It will be interesting to see what the future holds…

3 Four Pillars

The other reason is that I just can’t be bothered. :)

4 Mrs. Micah

I’ve decided that I’d rather watch from the sidelines. I don’t have enough money right now to have an investment strategy with high risk. In the future, if we max out our IRAs, 401(k)s, whatnot and feel like we’ve got more money to work with, I could see venturing a small amount on something like this (just as I don’t plan to buy individual stocks unless we’ve got “leftover” investing money).

I also recently ran across one man’s charting of Prosper defaults…and (more importantly, perhaps) late payments. Obviously needs to be taken with a grain of salt, but he explains his methodology and I think it’s worth a look.

5 Four Pillars

Mrs. Micah – I think you are doing the right thing. Getting debts paid off, saving for retirement is more important than the exact investment (ie p2p).

Thanks for the link to the other blog – some interesting info. Not as bright and cheery as the Prosper blog. :)

6 Dividend Growth Investor

Mrs Micah,

That late payment chart speaks volumes. If you loan out $10,000 to 100 people at an average rate of 20% annually, and 30% of the debtors default, then you are losing money. You’d be much better off getting a 3 year CD at 4% APY..

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