As an investor in P2P lending, I’m doing as much due diligence as possible to make sure I have the right portfolio that matches my risk profile. I’m at the lower end of the risk spectrum because I’m using P2P among other investments to replace my CDs which are coming due over the next four years.
One of the important things all investors in any type of asset class should do is analyze historical data. Obviously, historical performance will not guarantee future performance. However, historical data does give us a glimpse of what we might expect if we follow similar investments. A lot has changed in the past three years, most notably a decline in the risk free rate, and a recovering stock market.
With the 10-year yield under 1.7% and the S&P 500 dividend yield under 2%, I now have a minimum bogie to shoot for. My goal is 3X the 10-year yield, hence 5-6%. Now it’s time to figure out how to get there!
As you can see from the detailed chart, investor returns are inversely correlated with the borrower’s rating. Makes sense given the lower the quality borrower you are, the higher the investor demands in return. The chart also calculates the weighted average credit score per borrower rating category. Interestingly, the credit scores are not that bad at all, especially for those in the D, E, and High Risk rating categories.
WHAT WE CAN DEDUCE FROM THESE FINDINGS
* Ease of use is important. Borrowers are coming to P2P lending to find a quicker, less painful way to borrow money for their respective needs. I refinance my mortgage online and check the latest auto insurance rates once a year online because it’s so much easier than calling or going to a branch office to talk to someone. The internet is the main way everybody is doing everything now. Commercial banks need to get with the program and make borrowing money as easy as possible if they don’t want to lose more market share.
* Anonymous borrowing is important. The other feedback I get from borrowers of P2P lending is that they want to borrow anonymously. Whether it is due to guilt, shame or the desire for nobody to get up in their business, borrowing through P2P is slowly becoming a viable solution for many who cherish their privacy. It is always weird to get grilled about your personal finances by a stranger at a bank, even though they are sworn to secrecy. Not seeing someone during the application process ironically provides more peace of mind to some.
* Small differences in ratings are huge. The difference between a mediocre-to-good credit score (660-719) and a great credit score (720+) can lead to a four times greater borrowing interest cost! For example, if your credit score is 679 or worse, you are paying at least 27% to borrow money, because 27% is what the average investor of E and HR categories earn! Contrast the 7.36%-13.66% borrowing costs for those with 734 credit scores or better. Lending standards have tightened drastically as you’ve recently learned about how the average credit score for rejected mortgage applicants is 729.
* Everybody borrows money. People with great credit scores borrow money too. In fact, 70% of all borrowing in the chart is made up by people with credit scores of 700 or greater! We cannot underestimate how important pride and privacy is for borrowers. If I was ever in a bind, I would be willing to pay 5% higher rates via P2P lending for a couple years than go ask a friend, family member, or the bank for money. People think P2P lending is only for those with poor credit scores. Clearly, the borrower rating profile is spread throughout the spectrum.
* Loss rates peak at E and decline at HR. Loss rates generally increase the lower the borrower rating and credit score. However, it’s curious to note that loss rates decline at High Risk. As an investor who will invest in low risk and high risk notes, I will probably aim to invest in HR instead of E because my seasoned return is 2% higher.
UNDERSTAND “SEASONED RETURN” IS DIFFERENT FROM “YIELD”
Your return is based on the life-cycle of the underlying Notes within your portfolio. Because a Note cannot default until it’s missed five payments, the return for a portfolio composed solely of young notes will be based entirely on those loans that remain current. This can result in a temporarily higher return for young portfolios than should be expected.
As your Notes age, you may see initial defaults occur between their fifth and ninth months of age. Prosper research shows that loan portfolios that have reached 10 months of age more accurately reflect the likely long-term performance as the loans have had sufficient time to experience the impact of potential defaults. You’ve also got to assume borrowers paying off their loans early, which hurt returns. For that reason, Prosper provides “Seasoned Returns”, defined as the Return for Notes aged 10 months or more.
Seasoned returns is what long term P2P lending investors ultimately need to look at. In the chart above, season return = yield – loss rate. What’s important for higher risk investors to think about is that once you know what the average loss rate is, you become that much more comfortable in investing in lower ratings. You just need to have a diversified enough portfolio (100 loans or more average $25 each) to account for bad runs.
INVEST AND PROSPER
Based on the historical data, I will be employing a hybrid dumbbell strategy for my initial P2P investments. In other words, I’m aiming for a 70% weighting of AA/A rated borrowers (6%) and 30% weighting for HR rated borrowers (14%) to achieve a blended seasonal return of ~8.5%. As my bogie is 5-6%, I’ve got a 2.5%-3.5% buffer for more losses. As my P2P lending portfolio grows, I’ll continue to experiment with different strategies and report back.
Update 2H2017: Prosper sent a message to investors saying they overstated returns over the past several quarters. This is unacceptable because now investors can’t fully trust Prosper. I’d invest with LendingClub instead. They’ve had their ups and downs, but at least they are a publicly listed company under immense scrutiny from thousands of investors and the SEC. Trust is everything! I’m decided to wind down my Prosper positions.
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Updated for 2017 and beyond.
About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.