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Why I Don’t Invest In Peer-To-Peer Lending

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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 CL 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!

This post comes from Mike of Quest for Four Pillars, “another Canadian Financial Blog,” that traces its namesake to none other than the Four Pillars of Investing by William Bernstein.

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15 Responses to “Why I Don’t Invest In Peer-To-Peer Lending”

  1. Four Pillars says:

    As the author of this post I want to clarify that the original title was “Why I don’t invest in P2P lending”. I think it’s a perfectly legit avenue for investing but I don’t feel it’s right for me.

    Mike

  2. David says:

    It’s true that borrowers taking a 10% loan from P2P lending probably couldn’t get that loan from a bank, and:

    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.”

    I don’t think a borrower’s credit score is meaningless IF they are looking for a lower-interest loan to repay the debts that have them maxed out. It never looks good when somebody is maxed out, but I would guess somebody who is maxed out with a 700 credit score makes good on those debts far more often than somebody with a 500 credit score.

    Of course, there is no way to guarantee that is how they will use the loan, or that they won’t abuse the credit freed up by the P2P loan. This is why banks won’t lend more money in this case.

    But I think P2P offers an important third option for people trying to get out of debt (instead of bankruptcy or debt management), and it relies on lenders to provide that.

    The lack of tax benefits and risks are all something that should go into a lender’s plan for the interest rates they will accept. And, like all investing, I would never invest in just one borrower — I would loan small amounts, $25 or $50 each, to dozens or hundreds of borrowers at different risk levels.

  3. Mike says:

    I also disagree with your assertion that the risks are well understood. Prosper was the earliest of the P2P lenders, and they started loaning in November 2005. Since they issue 3 year loans, just a few loans have matured. Because of this, there’s very poor statistical information available. It’ll probably take another year or two to produce a good set of data to draw solid, predictable inferences from. If this makes you queezy, don’t put your money here.

  4. sucellus says:

    I think part of the point you are missing is that the traditional lending market is not flexible enough to deal with every type of borrower out there. Yes banks are good at STATISTICALLY figuring out how likely you are to default on a loan, but they don’t take into account all the factors. Let me give you an example from a few years ago.

    A friend of mine went through a really tough year where he lost his job and racked up a large amount of credit card debt. He was single, living on his own, and with no help from outside sources (parents, etc.). In addition, he had a problem with the university he had attended where they were claiming he still owed them money (he didn’t) and they reported the problems to the credit bureaus. He eventually got a new job and had been paying all his bills regularly, but because of the large amount of debt, the short term problems paying bills, no home to be used for equity, and the issues regarding his credit score he was unable to get a traditional loan. He was eventually able to get out of debt after a couple of years by doing some complicated juggling where he paid off a single card, negotiated a lower rate with that card and started doing transfers to that card. It took him years to pay off his debt; he could have easily paid it off if he had been able to get a reasonable interest rate. He would have gladly paid even 15% as opposed to the 30% he was paying to the credit cards.

  5. Four Pillars says:

    Thanks for all the great comments!

    David – you are correct in that you don’t know what the borrower is going to do with the money. Diversification is indeed the key.

    Mike – I never said the risk are well understood – quite the contrary, I think the defaults rates are understated.

    sucellus – I’m not sure how your friend’s example is relevant to an analysis of P2P lending from the point of view of an investor. I would agree that your friend would probably have benefited from being able to use P2P had it been available at the time.

    Mike

  6. sucellus says:

    I guess my point was that not only would he have been able to benefit from p2p lending, had it been available at the time, but that lenders would be able to profit from his situation. He fell outside the standard model of who banks will lend to, but not because he is a bad borrower, and thus there is money to be made by lenders who are willing to lend to borrowers like him.

    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.

    In my example we are looking at someone who has a lot of credit card debt at a high interest rate (30%). Since they can’t consolidate their CC debt into a more reasonable loan they are stuck in a bad situation that is not solvable in the standard banking market. And given the availability of p2p options that would be able to reduce that interest rate significantly and buffer him from rate hikes, and as such the lenders would reap a high rate of return.

    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.

    Actually, banks are only better at it when you fall into the standard categories, which is why they don’t lend to you if you don’t fall into their model. Once the borrower falls outside those norms (like my example) the current banking system doesn’t even try to provide an option. If they were trying to fill this gap they would probably be better at it, but since they aren’t there is money to be made.

    As a lender on Prosper if you want to set up some kind of automatic system where you lend to people based on certain criteria I think you are absolutely right and the risk is higher than the rewards, but if you put in the time to pick borrowers whose situations put them outside the standard borrowing options, but are still quality borrowers, you could make a lot of money and that is the whole point of being a lender.

  7. Four Pillars says:

    sucellus – That’s interesting – one problem however with a consolidation loan as David pointed out, is that if you loan through p2p then you have no control over what the borrower does with the money. If a bank gives a borrower a consolidation loan then they might have more control.

    In the case of your friend, you have to keep in mind that not everyone knows him as well as you do, so your typical lender has to look at the various ratios/scores etc and make a decision based on that. It’s not perfect as your friend proved but that’s the way it is. I would think that a P2P lender would be more willing to lend money to someone who is in the situation your friend was in (at a high rate) but there is no guarantee.

    Mike

  8. Brip Blap says:

    Hmm. Well, I’d stick by my assertion that P2P lending lets me be the bank. I’m providing capital, identifying loan candidates, doing collections (outsourced, of course). If I’m not the bank, I’m at least the president of my branch.

    You know why I like P2P lending? Because it’s one of the first steps to freeing the flow of capital via corporate entities in America. I like it because it’s a fresh idea, it’s somewhere to put my money besides the bloated stock market, and it’s just plain and simply interesting to work with. Would I invest more than 2%-3% of my investment portfolio there? No way. I feel that it’s a good niche investment. I’m not going to retire off of it, but I’ll certainly keep a toe in the water.

  9. FICO says:

    Mike, I have no problem with your opinions as long as the facts have been researched and verified. Yours obviously haven’t when it comes to P2P lending. It is a far cry to liken a P2P loan to a start up Bio or Mining Co. Ridiculous! One particular site only will offer loans to people with a 640 FICO and above..the average seems to be around 700. They certainly could get a loan from a bank, however, banks either hand you a CC application or charge you 18-22%, why not try and get a better deal. The interest rates are also set for the 3 yr term and they are based on that individuals FICO score. P2P lending isn’t for everyone..however, if you think keeping your money in 3%-4% CD is a smart move, when you could be earning 10-12% with the same risk(bad debt factored in)..you may be in the wrong business…

  10. Four Pillars says:

    FICO – Do you really believe that a p2p loan that pays 10-12% interest has the exact same risk as a loan (cd) that pays 3-4%? That’s impossible, if the borrower were that credit-worthy they wouldn’t be paying that kind of interest.

    The higher the interest rate, the higher the risk factor – it’s as simple as that.

    As I said in the post – I’m not at all against P2P lending. If it fits your investment plan then it’s a good tool, but like any investment it’s important to understand what you are dealing with.

    Mike

  11. FICO says:

    Four Pillars,
    My point is two fold:
    1) before you make recommendations, please get your facts about P2P Lending… straight or at least do a little more homework…
    2) If you are earning 12% in your P2P porfolio and your risk is spread out over 50-250 Loans, even allowing for bad debt of 1-2% (which is high right now) you are still earning 3x your money…..than letting it sit at 3%-4

    and it is actually the reverse..the higher the risk factor the higher the interest rate…not visa-versa

  12. Four Pillars says:

    FICO – nowhere in the post did I ever make any kind of recommendation – I only wrote about the reasons why I don’t have p2p lending in my portfolio at this time.

    What facts? The fact is that p2p lending has not been around long enough to properly analyze the data so I really don’t know what facts or homework you are talking about.

    As for the ability to make 12% with only 1-2% defaults – This is not guaranteed over an entire business cycle. Sub prime loans are a great example of a high interest rate lending plan which worked extremely well for a long time but when times got rough – they got really rough.

    High interest loans have a higher risk factor not unlike stocks so you have to be able to handle the ups and downs. Over the long run (ie 10-15 years or more) hopefully the high interest lending will have a good return but there is no guarantee – similar to investing in equities.

    Mike

  13. Eric says:

    As to the diversification argument, P2P loans should obviously only be a part of your overall well diversified portfolio. Lending all your risk capital to P2P borrowers is not “diversification”.

  14. Donald says:

    When someone has a 6 year relationship with a bank and a credit score of 780, an annual income of 100,000 and gets turned down by the bank for a 10,000 dollar line of credit, as is my case, it kinda feels nice that there is a lending institute that will lend my money. I plan on getting the money and using it to make money. My plan is simple and it works. I have no reason to not pay it back because it’s paying me.

    Personally I don’t like it when you work hard for a great credit score and still get turned down. I have been reliable year after year after year and still get a slap in the face by my very own bank.


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