How to Make a Wise Peer to Peer Lending Investment

Peer to peer lending investments - Franklin SocietyA few months ago, Kriss talked about the rapid growth of the peer to peer lending industry. He pointed out that there are a number of reasons that P2P lending is exploding. He is absolutely right – demand is growing as consumers struggle to secure loans and returns for lenders are great since they get to cut out the middle man.

However, there are still risks that come with lending anyone money, so it’s important to screen borrowers carefully before lending to them. Keep in mind that your loans aren’t FDIC insured like a savings account would be and everyday people are probably more likely to default on their loans than a major corporation.

Unique Challenges in Peer to Peer Lending Investments

According to polls from leading experts in the P2P lending industry, the average return on P2P loans is between 5 and 12%. These are certainly healthy returns, but risk is also high, since people that use P2P lending sites are arguably more likely to default than those that can get approved for a traditional loan.

Since the risk of default is higher than traditional debt instruments, William Jordan, a wealth management consultant in Orange County, recommends using P2P lending as a small share of your portfolio to boost overall returns, rather than as a dependable stream of income. This is practical advice, but you can significantly reduce the risk by conducting your own actuarial analysis of borrowers.

The Lending Club, Prosper and Upstart all have basic requirements all borrowers must meet. They must have a credit score of at least 640 to 660 to create an account. Unfortunately, that isn’t enough to eliminate your risk, because people with 650 credit scores can easily default on loans.

While P2P lenders take some steps to reduce the risk to their lenders, you’ll still need to scrutinize them carefully. On average, you would need to make 7.7 good loans to make up for the cost of one bad loan. The average borrower simply isn’t as creditworthy as a large corporation, so vetting those that are likely to default is very important.

One point to keep in mind is that people trying to borrow money from P2P sites often have trouble securing traditional loans. They probably wouldn’t be paying higher interest rates if they had another alternative. You will need to distinguish between less risky borrowers that simply didn’t meet traditional actuarial standards and those that are likely to default.

The risk of the borrowers defaulting isn’t the only thing that you need to worry about. You also need to come to terms with the fact that there is less liquidity with P2P lending than holding bonds or other debt securities. This will be true regardless of the nature of the loan, but it will be especially a concern if the borrower is requesting a large loan that they plan to pay off over a number of years. If you are anxious to get your money back within a couple of years, then you should stick to making loans under a few thousand dollars.

Conducting a Risk-Analysis of Borrowers Before Committing to a Loan

The identities of the prospective borrowers are confidential, but you’ll be able to learn a lot about their credit history, education and other pertinent information to help you decide whether it’s worth lending to them. Make sure that you research the borrower thoroughly before committing to a loan, because some may not have the means to pay you back.

Risk is an inevitable element of investing and P2P lending is no exception. However, there are a variety of steps that you can take to mitigate the risk. Here are some tips to consider.

Consider the Demographics of Borrowers

Understanding the demographics of your borrowers is an important part of the lending process. Some P2P platforms tend to cater to certain demographics over others. 

For example, Upstart’s P2P lending platform focuses primarily on younger buyers, many of whom don’t have a credit history. It can be difficult to vet borrowers there since you don’t have much information on their credit history. Younger borrowers may also be more likely to make impulsive decisions such as changing careers on a whim, so you may need to be more cautious lending money to them unless they have a stable employment track record.

Pay Attention to Letter Grades

P2P platforms provide letter grading systems to make it easier for borrowers to assess the risk of their borrowers. The Lending Club has borrower grades between A and G. It’s best to focus on borrowers with a grade of an A or B, which usually means that they will have a FICO score of 720 or higher.

Looking at these grades can be helpful, but you can’t rely on them too heavily. Debt-to-income ratios, the nature of their loans and employment stability are all important factors to consider as well. Their letter grades are a good starting point, but don’t let them make you complacent about lending $50,000 to someone that says they want to start a new biotech firm.

Look at Education with a Grain of Salt

Conventional wisdom has always been that more educated people are less risky borrowers even if they don’t have a great job lined up, because they are likely to get a good paying career in the new future. That rule of thumb no longer holds true, because a college degree is no longer a guarantee of employment. Recent graduates with social science degrees often find they are more of a liability, because they have a lot of debt and few job opportunities.

Upstart points out that this can be great for understanding potential employability, but I personally think they are overly optimistic. Bear in mind that 51% of recently minted college grads that have a job at all are working at Starbucks or another dead end job.

The job market probably won’t be improving any time soon, so your safest bet is to lend money to people that have job offers already. If you are going to take a chance lending to a young borrower without a good paying job, make sure that they are at least in a field with decent employment prospects and ideally have a good employment history.

Upstart says they are the first site that lets lenders see the education profiles of potential lenders. You will probably be better off lending money to someone that completed a degree in business or engineering than art history or theater.

Purpose of the Loan

The credit and character of the borrower aren’t the only relevant factors to take into consideration. You also need to know what they are seeking the loan for. Some borrowers will need to be scrutinized more carefully if they are asking for money for something risky.

A borrower that is seeking money to purchase a car to get to their new job is probably a fairly safe investment. As long as they received an offer for a decent paying job, then you shouldn’t have any trouble getting them to pay you back as long as their credit history checks out well.

An entrepreneur starting a new business is a horse of a different color. They are much more likely to default, because 90% of startups fail. If you are going to be lending to an entrepreneur, then you need to lend to screen them carefully first. Here are some factors to look at:

  1. Are they starting a business in a field that is related to their prior employment?
  2. Do they currently hold a decent paying job that they intend to keep? They are a safer investment if they will have a reliable stream of cash flow.
  3. Have they ever started a business before? What is their track record?
  4. Will they be purchasing capital that they can use as collateral to cover the loan?
  5. Did they take the time to create a business plan?

Other borrowers can also be highly risky. You need to be more careful about lending money to someone that is trying to purchase a new house than someone that wants to buy a car, because it will take longer to repay the loan, which increases their chances of defaulting.

Look for People that Are Trying to Be More Responsible

One of the reasons people try to borrow money on P2P lending sites is that they made past mistakes which set off alarm bells for traditional lenders. However, that doesn’t necessarily mean that you shouldn’t lend money to them. Borrowers are much safer if they are clearly trying turn over a new leaf.

 Look for people that are clearly trying to pay down their debts. Kenneth Lemke, publisher of Lendstats.com says to stick to loans from borrowers who have had three or fewer credit inquiries in the past six months and who report that they have credit-card debt that they are looking to pay off.  These people are clearly monitoring their credit history, which suggests that they are working hard to improve it.

Duration of the Loan

The risk of default increases with duration of the loan. Few people fail to repay loans over the course of six months, but the risk rises significantly when lending to borrowers looking for loans of three or more years. Prosper and LendingClub don’t have any data on default rates after four years, which makes it impossible to even know the risk.

You may want to avoid lending money to people that want to pay off a loan over the course of four or more years. If you do plan on issuing a longer-term loan, then you may should consider requesting a higher interest rate to compensate you for the risk.

The Importance of Diversification

Diversification is always a good way to hedge the risks of making bad investment decisions. How do you diversify with P2P lending? Your best bet is to loan money to a variety of different types of borrowers.

Keep in mind that no matter how carefully you screen your borrowers, there is always a chance that they will default. Leading P2P industry experts recommend spreading your risk across a number of borrowers. Some experts recommend making at least 100 loans to reduce your risk profile.

You also need to make sure that you aren’t lending to a homogenous class of borrowers. The risk of making loans to 100 consumers trying to buy condos in Milwaukee is much higher than making loans to 100 homebuyers across the country, because a sudden setback in the local job market could cause substantial numbers of people to default on their outstanding loans. Similarly, only lending money to people in a specific profession can be risky, because changes to the industry can force a large number of them into unemployment.

Screen P2P Borrowers Carefully

Lending money is always going to be risky. You can’t eliminate the risk, but you can drastically reduce it by verifying the creditworthiness of borrowers. P2P lending platforms like Prosper and the Lending Club offer a lot of information to make your analysis easier. However, you are going to have to do a lot of your own homework to minimize the risk they will default.

There are a number of factors that you will need to consider when lending money to them. The borrower’s credit score, employment, income and nature of their loan are probably the most important variables.

Have you ever lent money through a P2P lending site? What steps did you take to minimize your risk? Please feel free to share your comments below!

3 comments
Martin Says

I have been a lender with Prosper.com for a little over a year. This is the best alternative I’ve found for the cash portion of my portfolio. I only invest in the highest grade loans that pay the lowest rates (min score I’ll invest in is 720); however I’m making 9.44%. Where else are you going to get that kind of return on cash? The key is being well diversified. For every $1,000 I invest, I invest in 10 $100 loans.

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Joe

I live in Alabama which is apparently not open to investing. Are there any alternatives? Such as a different site than Lending Club, or possibly setting up an LLC in a different state?
Thanks for the great information!

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Dorman Wainright

Martin is right. Prosper has been a nice source of income for me too. You have a wide range of choices for the risk you’re willing to take and can earn very close to 10 percent on the investment. I’m glad the option is out there for us investors, especially , like Martin said, for “the cash potion” of a portfolio.
DWainright

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