P2P Investor Returns By Borrower Rating And By Credit Score

As an investor in P2P lending with Prosper, 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!

Prosper Returns By Rating

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.

CONCLUSION

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.

If you are interested in investing in P2P lending to earn higher returns, you can click Prosper to sign up. Feel free to share your P2P investment findings and strategies if you are already an investor.

Regards,

Sam

Prosper allows investors in the following 29 states: Alaska, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Louisiana, Maine, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New York, Oregon, Rhode Island, South Carolina, South Dakota, Utah, Virginia, Washington, Wisconsin and Wyoming.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

You can sign up to receive his articles via email or by RSS. Sam also sends out a private quarterly newsletter with information on where he's investing his money and more sensitive information.

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Comments

  1. Cosmic says

    I looked at P2P lending a couple of years ago when I was frustrated at the overall rates at banks. Unfortunately, Prosper isn’t available to people in certain states. I’ll wait and see if it expands to my state in the future. Keep us posted…

  2. Untemplater says

    Double digit rates on borrowing gets expensive quick. But if borrowers need the loans at least they have the option. It’s funny how only certain states allow investors to use p2p. Given CA is usually strict and weird with its rules thats cool to see they allow it!

  3. Jeremy Noel Johnson says

    I think I’ll add this to my investment strategy as I continue to look at Real Estate, work on my website, and do the mobile app. As a noob to this, I think it will be a great thing to journal and write about to see if I can have success with it. This might help other noobs like me try it out :)

    • Financial Samurai says

      Pace yourself Jeremy! Having a blog to write about the journey is definitely a great way to learn and improve performance. This is what I’m doing as the idea is that more heads are better than one. In investing, the more stones we can turn over, the better.

  4. Brian says

    Thanks for the information, I’ve been seriously looking at this as well. I think it’s time to dip my toes in the water.

    • Financial Samurai says

      I specifically asked Prosper reps how they got to their advertised investor rate of return (Currently 9.69%). They said it was 100 loans at $25 or more each to achieve their stated returns since 2009. And as you can see from the post’s chart, I dug the information up to highlight that this indeed looks like the case.

      Diversification is obviously a no-brainer when it comes to P2P lending. The question is, what is the diversification strategy to maximize returns based on one’s own risk profile.

  5. Grandpa says

    I too am interested in P2P lending. With savings and money market rates as low as they are, who can blame us?

    One caveat to keep in mind is the general state of the economy. For example, if we go over The Cliff, or some such event as the Lehman Brothers collapse, the current unemployment rate of 7.7% (I know this lies on the low side) may skyrocket back to 10, 12, 15 percent. Under these conditions, many loans may elect to just quit paying, particularly if one or more of the households has lost their job. The very thing that Sam said that they like the anonymity of borrowing this way, may also factor into their decision to elect this loan as one they are not paying.

    • Financial Samurai says

      Good point Gramps. Although, I highly doubt we will rocket back to 10%+ unemployment even if CONgress does nothing. The reason is, by the time we get to 8.8% unemployment, the government will be forced to do something, otherwise face getting impeached.

      Losing power is a politician’s worst nightmare!

  6. Gen Y Finance Journey says

    This is really useful information, Sam. I’m excited to start investing in P2P lending, but I’m going to start small. Well, I have to start small, since I don’t quite meet the income requirement for California, so I couldn’t invest more than $2500. I was thinking of starting even smaller than that though to get my feet wet. Maybe just $500-1000.

    Do you have any opinion on Prosper vs Lending Club?

    • Financial Samurai says

      I would definitely start small first and see how it goes. Although, if you started with a $10 million portfolio of thousands of A level loans, you’d probably mimic the results above!

      I’ve never used LC before. They are very similar. I decided to go with Prosper because I have personally met representatives there who talked me through their business and the P2P process. They are both based in SF and I believe Prosper started earlier than LC, but are smaller, hence more attentive service. I like service!

  7. Mike says

    I’m currently in Lending Club with $1500, but I’m now pouring $1000 monthly and I’m mostly targeting higher risk / higher return loans, but I’m only doing three-year loans. I recall reading a post recently about borrower psychology which suggested that people won’t default in their first year of a loan because they are enthusiastic, or the last year because they are almost paid off. The risk is the middle year(s), so I’ve tried to minimize that by only giving them one year to default!

    I also don’t want my money tied up after three in case I need to jump and do something else, plus like some, I’m a little jumpy about the long-term prospects for the broader economy!

    If I start to run out of decent note opportunities over at LC, I have an account with Prosper I’m going to try as well!

    • Financial Samurai says

      Pouring $1,000 a month is impressive Mike! Excellent point on borrower psychology regarding three year loans.

      I think once we get through a budget resolution in Congress, it is going to be mostly sunny skies with scattered showers on the horizon!

    • Scott says

      With $1000/month, how much per loan are you now investing? It would seem managing 40 new loans a month (at $25) would take a lot of management time!

    • Tek Lentine says

      Mike:

      What you said about borrower psychology and the middle year of a 3 year loan being the highest risk of default does sound logical, but does not match up with data.

      In actuality (using my own analysis of Prosper’s raw data), the highest risk for default on Prosper occurs within the first 12 months, especially within the first 6 months, and then steadily drops to zero as the final payment date approaches.

      In a nut shell, the older the note, the lower the chance of default.

      • Mike says

        That’s a good point and one I’ve had to reckon with lately. I would amend my statement by saying that there seems to be people who default early, probably because they were never committed to doing anything BUT default the moment that they received to loan. I had one note who filed bankruptcy within the first three months of the loan. I wonder of you select them out, whether or not the remainder of my comments on borrower psychology hold?

  8. Kim@Eyesonthedollar says

    I would think Prosper would be very attractive to those with higher credit scores who are wanting to start or buy a business. Commercial loans are difficult for several reasons and can take a long time.

    • Financial Samurai says

      Yeah, things are much different now and the entire industry is SEC regulated. I’ve known about them since the beginning b/c I worked in finance, but I waited until seven years later to invest. I have one buddy who has over $250,000 with Prosper and he couldn’t stop saying enough about his returns. He didn’t lose money during 2009-2010 either!

  9. Justin@TheFrugalPath says

    I’ve been thinking about getting into P2P lending lately and got bummed out when I read that my state didn’t apply. I haven’t reached that stage in my investment strategy yet. But hopefully by the time I’m ready prosper will have entered my state.

  10. Jon @ Pay My Student Loans says

    P2P investing makes a lot of sense, removes the middle man and allows for more people to keep more of their money. But the established banks also help keep a balance between supply(money to loan out) and demand (people looking for money) from the current P2P returns it looks like the the demand right now is outstripping the supply and driving up the interest rates but my bet is that will eventually swing the other way and people will lose money. But that is just my theory and I have been wrong before!

    • Financial Samurai says

      Actually, borrowing costs and returns have come down over the past three years given the 10year risk free rate has come down.

      What seems stubbornly high are credit card interest rates at 15%+!

  11. Financial Samurai says

    @Cosmic Will definitely keep everyone posted. I plan to write a couple P2P related articles a month to help investors and borrowers alike. Savings rates and CD rates are just way to low right now.

    @Untemplater I have a feeling that more and more states will allow P2P lending over the years. It’s SEC regulated and is demonstrating it’s credibility each day that passes. It’s been seven years now.

    @Brian No problem. Dipping in is always a nice option than jumping in head first. My posts are a way of putting a leg in the water now.

    @Kim@Eyesonthedollar Starting a business is definitely one of the main reasons why those with good credit come to P2P. It’s the American dream, though big banks are making it hard to get a loan nowadays.

  12. Darwin's Money says

    Ahh, I gotta say I’m really bummed our state banned P2P “investing” a few years ago and I had to shutter my Prosper account. Granted, I happened to have start at the worst possible time heading right into the recession and after accounting for the defaults/write-offs I my real return was something like 2% rather than the double digits I was initially projected at going in. But coming OUT of a recession, you’d think perhaps you’re still getting above market yields per given risk and defaults may continue to drop if the economy improves. It’s all about diversification of loans!

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