Banking 
5
comments

Avoid These Three “Short-Term” Loans

Payday Loan StorefrontIn an ideal world, when you needed to borrow some money, you could just walk into your bank and just ask. However, banks are funny in that they generally are willing to give you money when you don’t need it but are less forthcoming when you actually need it. In these harder economic times, those in need of money may be tempted to turn towards other “financial institutions” for short term loans and I’m here to try to dissuade you. These are horrible short-term loans with horrible terms (and their high probability of becoming extremely expensive long term loans) and should be your last resort if you’re in need of cash.

“Refund Anticipation Loans”

These are loans offered by tax preparation firms based on your tax return. They offer them because they know exactly how much of a return you’ll be getting, when you’ll be getting it, and how much money they’ll be making by lending you that money a few weeks early. They’re expensive loans, despite how safe they are, and they’re packed with tons of fees. The industry earned over a billion dollars in 2006, I wonder how many of those dollars were earned from folks who didn’t know they were getting a loan in the first place? Probably more than you’d think.

Payday Loans

Need a few extra bucks to make it through to your next paycheck? How about a little extra scratch so you can get a gift that’s extra special? Payday loans typically have ridiculous high interest rates (think four digits and that’s not counting the decimal places) and their fees are atrocious. The scary part about payday loans is that most people only get one for a few hundred dollars so it doesn’t seem like all that much… then they get socked with fees and then something goes bad and then before you know it you’re going down the mountain with one ski and a prayer.

Credit Card Cash Advances

You might be tempted to stick your credit card into an ATM and simply withdraw some money but take heed. In addition to the interest you may pay by carrying that balance from month to month, cash advances are typically charged an additional fee based on the amount withdrawn. Most credit cards charge 3% of the advance and add that to the amount withdrawn. $100 becomes $103 and, if you carry that from month to month, can have a serious impact. A cash advance is not as bad as a RAL or a payday loan.

Better Sources of Short-Term Money

Need money for the short term? Here are some suggestions, in no particular order, that are better than Payday loans but not exactly ideal themselves:

  • Try the bank – you never know.
  • Cut other expenses so you’re spending less.
  • Ask your employer for your paycheck a little early.
  • Borrow from friends and family.
  • Consider peer-to-peer lending sites like LendingClub or Prosper.
  • Use your credit card for purchases and consider a card with 0% APY on purchases promotion. It’s not ideal but will give you more breathing room.
  • If you owe someone money, try to negotiate a deal. Delayed payment beats bankruptcy.

If you’re in good shape now but on the fringe, consider cutting some expenses so you can bolster up the emergency fund. It’s far easier to get money out of a bank account than it is to get it from anywhere else.

Anyone else have any ideas?

(Photo: andrewbain)


 Investing 
15
comments

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

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.


 Investing 
12
comments

LendingClub Review: Another Peer to Peer Lending Marketplace

Try it Now! Join Lending Club.LendingClub is another player in the growing peer to peer lending marketplace and one that I signed up with despite my reservations with the whole peer to peer lending craze. I joined because online savings account interest rates have fallen sharply in recent weeks because the Fed lowered the target funds rate so quickly. With the stock market in turmoil and other investment options less attractive, the idea of peer to peer lending has gotten more appealing.

Sign Up Today!

The idea behind peer to peer lending is that you lend a little bit of money across numerous loans. By diversifying, you lower the risk. If one loan defaults, you lose only a small amount. As a relatively risk averse person, I don’t like any loans defaulting but you accept a higher rate of return for that risk. When some default, the rate of returns lowers and you get somewhere closer to market rates. It’s the same strategy banks use, except “little” for them is many hundred thousands of dollars!

LendingClub is pretty much the only game in town as Prosper just entered a quiet period. LendingClub just exited a quiet period because they had to register with the SEC since the loans are considered securities. Prosper may never leave the quiet period but LendingClub has, so you won’t have to worry about that in the future. One nice benefit of the loans being registered as securities is that you can sell your interest in the secondary market!

Account Signup

The signup process was easy and I had an account up and running within minutes. Setting up my account so I could begin lending was also trivial, a four step process of entering my personal information, bank information, and some association information (school I went to, employer, etc. but these were optional). The account process proceeds with the typical bank account verification process of small deposits.

Default Rates

It appears that LendingClub’s default rate and other lending stats are rosier than the likes of Prosper and others, but that could be because they are much newer to the game. Techcrunch did a brief writeup on LendingClub and noted the same thing about the default rates, expecting them to rest close to what Prosper was seeing. Ultimately it appears that both should have similar statistics with regard to late payments, defaults, and other lending related statistics.

One thing that does give me a little faith in their system is the borrower requirements:

Lending Club only accepts borrower members who are U.S. residents and whose FICO score is at least 660. Borrower members must also meet additional credit criteria:

  • a debt-to-income ratio (excluding mortgage) below 25%, as calculated by Lending Club based on (i) the borrower member’s debt reported by a consumer reporting agency and (ii) the income reported by the borrower member, which is not verified unless we display an icon in the loan listing indicating otherwise;
  • a credit report without any current delinquencies, recent bankruptcy, collections or open tax liens;
  • at least four accounts in the credit report, of which at least three are currently open;
  • no more than 10 credit inquiries in the past six months;
  • utilization of credit limit not exceeding 100%; and
  • a minimum credit history of 12 months.

That already raises the bar.

Next Steps

The next step is to fund the account and start reading up on the loans!

Sign Up Today!


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