Several years ago, a few smart people came up with a way to facilitate loans between individuals that would both benefit the the borrower through lower rates than a bank would offer, and the lender, through higher percentage yields than they could count on in the stock market: Peer-to-peer lending!
What peer-to-peer lending sites like Prosper and Lending Club do, is apply the crowd funding technique popularized by sites like Kickstarter and Indiegogo, and apply it to lending money (perhaps they were also influenced by micro-loan non-profits like Kiva). A potential borrower will request a loan of any size, provide details about the purpose of the loan as well as basic information about income, expenses, and credit score (which the site will verify, with the exception of expenses), and choose the pace at which they will pay it back (usually 3-5 years). The site will then assign an interest rate, and a letter score from A to F based on the borrowers credit record.
Lenders peruse the site, and buy up small pieces of many loans (called notes), lowering their individual risk in the event of default by investing only a tiny portion of their total allotment with a single borrower. In this way, small chunks of money, usually ranging from $25 to $100 from any one lender, add up to the total amount that the borrower has requested, allowing them to build their backyard pool, make a major purchase, or much more likely, pay off their credit card debt (approximately 80% use their loans to pay off other debt).
Over time, the borrower pays off the debt, and the lender gets back the principal as well as interest, minus any money their borrowers failed to pay.
If this sounds like a potentially scary equation to you, you’re not wrong. Initially Prosper’s platform allowed lenders to bid down other investors, creating unrealistically low interest rates. Combined with allowing anyone to invest, regardless of credit score, this was a recipe for a lot of people losing money, which they did, leading to a class action lawsuit.
Lending Club entered the game slightly later, and were slightly more conservative, immediately requiring a minimum credit score (which they’ve since raised), and setting interest rates automatically through the site. The site now boasts 95% of its investors with greater than $20,000 make between 6% and 18% back on their investments and was recently bolstered by Google purchasing a minority share in the company for 125 million dollars.
Despite the fact that I don’t have $20,000 to invest at the moment, I decided to give lending club a try. I put up $1,000. I’ll give you my first impressions here, and keep you updated about the how well the investment pays off.
Unfortunately, the state of Pennsylvania won’t allow me to invest directly into new loans. This has to do with the notes being categorized as stocks, and is more complicated than I fully understand. Here is a handy chart of which states allow what kind of peer-to-peer investing.
I was, however, able to purchase notes from other investors through their note-trading platform, called Folio. Essentially, I can buy ‘used’ notes which other people are trying to get rid of. There are lots of reasons someone might want to liquidate their portfolio before the completion of loan, but as you can guess, many of these notes were people attempting to unload delinquent borrowers at heavy discounts.
The site itself is super clunky, and it takes some searching to find notes that are actually worth buying. I set search terms for notes that are current, and have never had a late payment. Then I looked for notes that cost around $25, and were being sold for close to the value of the principal plus the interest accrued since the last payment.
I ended up buying 31 notes, valued from $12-$100. I bought two notes that were “within the grace period,” and were listed at heavier discounts, and paid between 0.5% and 3% under ‘face value’ for all my notes.
Another annoying thing about the site, payments take 4 business days to process, which just seems agonizingly long.
Some things I noticed about my borrowers:
- They are almost all paying off debt of some kind.
- The few that aren’t paying off debt have much higher incomes. They’re building a pool, doing home improvement, and making an (undisclosed) “major purchase”. Not sure how I feel about that last one.
- Often the justifications for the loan are very sparse, sometimes one sentence or less. Many lenders have asked questions of the borrowers, mainly how much of their income they currently spend each month, but sometimes they give almost no information besides the essentials.
- Every single one of my notes comes from a borrower with a higher monthly income than me. Some of them are startlingly high, like the pool guy, who makes $34,000 a month, but is borrowing $30,000.
In conclusion, we’ll see how this goes. I’ll write an update a few months down the road, but for now, I’ve received one payment from an “in the grace period” borrower totaling a whopping $1.68 ($1.28 in principal, $0.40 in interest) and have payments in process from five others. My other “grace period” note shows no progress.
One final thought: If you had a good enough credit score, could you borrow with a low interest rate, invest the borrowed money in high-interest rate loans, pray your borrowers don’t default, and reap the benefits?
Answer: Mathematically, definitely possible, but I have neither the credit rating, nor the guts to attempt something like this!