What Is P2P Lending?
In peer-to-peer (P2P) lending, borrowers request loans, and individual investors provide money in return for monthly repayments of principal plus interest. A number of online companies serve as mediators, vetting potential borrowers’ requests, administering the myriad of financial details and collecting a few fees. If you’re wondering how prevalent or worthwhile P2P investing might be, consider that one lending company alone funded more than $2 billion in loans in 2015’s third quarter:
- Nearly 70 percent – 67.7 percent – of those borrowers stated that they needed the loan to refinance or consolidate debt.
- Investors enjoyed a median account return of 7.5 percent; those in the 90th percentile reaped returns of 9.4 percent while even those in the 10th percentile earned 5.9.
Three Big Questions
1. Who Are the Companies?
A number of P2P lending companies operate within the United States: Lending Club, Prosper, Upstart, Funding Circle and Peerform, just for starters. While the first two are open to individual investors in most cases, the others accept funds only from accredited investors – individuals with a net worth of $1 million or annual income of $200,000 individually or $300,000 jointly if married.
(You might also be interested in a review of Lending Robot – a robo-advisor for peer lending.)
2. Who Can Participate?
State rules govern whether residents can participate in peer-to-peer lending or investment, and many states have income and net worth requirements. Generally, for Lending Club, residents of 41 states and the District of Columbia can participate. Prosper’s map showed 30 states and the District as well. For would-be investors in Pennsylvania, New Jersey or Maryland, for example, neither is an option. In contrast, residents in many other states – New York, Florida, Texas or California, for example – can take their pick or invest in both.
3. Are Investments Protected?
P2P loans are unsecured debt: they are not FDIC-insured. However, lending companies perform credit checks and verify borrower information before entering a loan into the marketplace. For example:
- The average Lending Club borrower has a FICO score of 699 and earns $74,414 a year. As of 2015’s third quarter, Lending Club’s default rate was 3.86 percent.
- The average Prosper borrower’s profile is similar. As of 2015’s third quarter, Prosper’s default rate was 4.24 percent.
- The average Upstart borrower has an average FICO score of 693 and an average income of $110,637. So far, Upstart reports a default rate of zero.
Criteria Worth Considering
Personal loan amounts typically stop at $35,000, but some companies fund small business loans for up to $300,000 or $500,000. Loan terms and interest rates correlate to applicants’ credit scores and history:
For example, while Lending Club applicants can have credit scores as low as 660, loan grades range from A to G, with five sublevels for each grade. In September 2015, B loans carried an average 10.95-percent interest rate while a C was 14.16 percent and an E 20.07.
Prosper’s minimum credit rate requirement is 640, and while A and B grade loans may be for as much as $35,000, grade C borrowers are limited to $30,000, grade Ds $25,000 and grade Es $10,000.
Individuals can invest in loan notes for as little as $25, as no investor typically carries any borrower’s entire loan; companies accepting only accredited investors may require $100, $1,000 or even $10,000. Either way, loans are divided among numerous lenders willing to back notes for those selected grades. Higher risk, higher interest loans – like those at 25 or 27 percent, for example – offer greater returns on investment, but they also carry more risk for borrower defaults. Historical average return figures for Lending Club by loan grade show a:
- 5.21-percent return on grade A loans at 7.72 percent.
- 7.34-percent return on grade B loans at 11.8 percent.
- 8.74-percent return on grade C loan at 15.22 percent.
- 8.92-percent return on grade D loans at 17.17 percent.
- 9.55-percent return on grade E loans at 20.96 percent.
- 8.99-percent return on grade F and G loans at 23.47 percent.
Prosper’s figures were slightly higher, with borrower interest rates ranging from 5.99 to 31.72 percent yielding 5.48 percent for AA loans, 6.78 for As, 9.47 for Bs, 11.14 for Cs, 10.74 for Ds, 11.35 for Es and 10.78 for their HR, or high risk, borrowers.
Investors can offset risk by diversifying, investing in notes of various grades.
Prosper, for example, contrasts two investors. Each lends $7,500 total at a 23-percent lender rate, with a final loss rate of 10 percent after all loans are paid in full. However, one lender selects five loan notes while the other distributes money across 150, each starting with an expected return of 12 percent:
With five notes, the probability for returns varies wildly, from negative 21 to positive 23 percent, the likelihood of a yield greater than 7 percent only 58.9 percent.
Diversifying through 150 notes puts the likely range of returns of 8 to 17 percent at 97.43 percent.
However, investing in five notes requires a minimum $125 while funding 150 notes requires at least $3,750.
Costs of Doing Business
Both Lending Club and Prosper charge lenders 1-percent monthly fees, as do most others. Lending Club takes 1 percent of amounts received from borrowers within 15 days of the payment due date. Prosper charges the same 1 percent but calculates it from the borrower’s principal balance prior to applying the current payment, so the fee actually dwindles as the balance decreases.
If you’re fortunate enough to be an accredited investor, Upstart allows lenders to invest fee-free, relying only on origination fees typically charged to the borrower. Funding Circle takes 0.08 percent monthly, slightly less than the typical 1 percent.
Chargebacks and Defaults
If a borrower is late with a payment, investors share the funds and accompanying borrower’s late fee. If a borrower defaults, however, chargebacks come into play. The loan will continue to accrue interest, but any payments received are typically subject to fees from 18 to 40 percent to cover collections and legal expenses. Currently:
- Lending Club deducts an 18-percent fee on payments collected without litigation and 30 percent of hourly attorney’s fees.
- Prosper reserves the right to deduct up to 40 percent of any money recovered.
- Upstart will convey the borrower’s origination fee, 1 to 6 percent of the loan principal, to the lender.
P2P lending returns must be reported and are treated as taxable income unless you open an individual retirement account – IRA – or 401(k). Both Prosper and Lending Club support various forms of IRAs while the latter goes on to offer 401(k), joint, trust, corporate and custodial accounts. Both P2P lending companies disburse 1099s at year’s end for notes that yielded $10 or more in interest. Investors may have numerous notes that did not yield $10 or more each, but the sum of all note interest must still be reported – and taxed accordingly.
Other Financial Options
As for the obvious question of how P2P investments compare to other, more traditional financial options:
- Regular savings are currently earning 0.03 percent to 0.06 for preferred customers.
- $10K money market accounts are currently earning 0.10 to 1.10 percent.
- $100,000 jumbo 5-year certificates of deposit are at 2.25 percent.
- Bonds earn even less, with EEs earning only 0.10, Is earning 1.64 and HHs earning 1.5 over 5 fixed-rate years.
- Stocks historically claim a 7-percent return, but a study by Richard Bernstein Advisors, LLC, found that the average investor’s marketplace behavior typically earns a more modest 3.7 percent, especially when marketplaces become volatile.
The ultimate question with any investment is how convertible the financial vehicle is, and that may be P2P’s greatest weakness. Once an investor lends money, that money is gone, literally spent to pay off a borrower’s debt. Ideally, investors regain every penny of principal loaned plus interest for their trouble, but the money returns in monthly installments.
Many investors accept this, promptly using those returns for additional investments, but cancelling a loan or “withdrawing early with penalty” is not a viable option. Lending Club and Prosper do participate in the Folio Investing Note Trader platform, where investors can trade and sell notes for a 1-percent seller’s fee, often at less than note value.
Whether investing in P2P lending is profitable may be answered best by looking at Lending Club’s investor composition figures over the last several years:
- In 2010, a full 100 percent of investors were self-managed individuals.
- In 2013, institutional investors made up 12 percent, individuals investing through managed accounts made up 59 percent, and self-managed individuals made up 29 percent.
- In 2015, institutional participation accounted for 28 percent, managed individuals decreased to 49 percent, and self-managed individuals continued on at 23 percent.
Meanwhile, the number of loans issued continues to increase. U.S. consumer debt totals $11.4 trillion. Small business debt totals over $1 trillion. Household credit card balances alone average over $15,000. The typical recent college graduate carries $35,000 in student loans, and medical expenses are the primary cause of bankruptcy. The demands of modern lifestyles make debt the watchword of the decade, perhaps the century.
P2P online lenders have gained a secure, legitimate foothold in the personal and small business loan marketplace, offering savvy investors endless opportunities to earn significant returns on a dollar well-placed.