An interview with Jeff Clements about p2p investing shows you the criteria to make stable and strong returns in p2p loans.
I’ve been investing in p2p loans for years and am always surprised that more investors are not in the new asset class. In this article, I talk with a long-time p2p investor about his experience and look at some of the ways to boost returns and reduce risk around peer lending.
The average investor made just 2.6% annually over the ten years through 2013…and even that might be tough going forward. A panel of experts including Jack Bogle, Bill Gross and Charles Schwab have sounded the alarm on low stock returns due to weak economic growth and low interest rates.
Despite all this, investors are still expecting stock market returns of 8% or higher over the long-term and using that to plan their retirement.
If it were not for one new type of investment, they could be in for a rude awakening as low portfolio returns leave them far short of their investing goals.
Can P2P Investing Save the Modern Investor?
Jack Bogle, founder of Vanguard Funds, warned Morningstar early in 2016 that stock market investors were likely to see annual returns of just 6% over the next decade. That’s before accounting for inflation so your actual real return would be closer to 4% annually.
Add in poor investor behaviors like panic-selling and buying at the market’s peak and there is no way most investors will reach their retirement goals.
Except one new asset class is offering investors the chance to boost their returns and reduce risk around an all-stock and bond portfolio.
Peer to peer investing is surging in popularity as investors look for investments that provide stable cash flow and higher returns.
The following is an interview with Jeff Clements, a long-time investor in p2p loans on Prosper. Jeff is not a numbers guy, he’s got no formal training in investments or stock picking, yet he has been able to make more than $10,000 in peer loans and his portfolio has returned almost 12% annually over the last six years.
Jeff owed me a favor so grudgingly agreed to share (most) of his secrets to picking peer loans and p2p investing. I have included my own comments below in italics so as not to be confused with Jeff’s.
Wow, nearly 12% and more than 10,000 in interest Jeff, thank you for sharing your story.
Glad to help as long as all the good loans do not disappear.
What is Peer to Peer Lending and Investing in P2P Loans?
Peer to peer (p2p) lending is simply a platform for individuals to request a loan from funding sources outside of banks. Lenders and p2p investors are made up of everyday people throughout the United States who are willing to assume a portion of the loan. For instance, say “John” wants to borrow $10,000 dollars.
Money is pooled from various individuals, each assuming a percentage of the loan. Say 20 people each agree to loan $500 at an interest rate of 24%, then Prosper combines the money and issues the loan. Individuals are then paid both interest and principle monthly based on interest rate and their percentage of the loan.
Ok, you may not have needed the starter explanation but I am often amazed at some of the comments and questions I receive to the site. Investors that are hesitant to open a peer lending account because they believe it is one investor per loan, that they will be funding entire loans themselves.
Investors have a choice of how much they invest in any one specific loan, as little as $25 or as much as they like. I guess when you work at something for so long, you start to assume basic information so a special thank you to Jeff for spelling it out. Check out an earlier post on Peer Lending Sites Reviewed for more detail into Lending Club and Prosper.
How did you hear about p2p investing?
I can still remember when I discovered Prosper and p2p lending. Sitting at my in-laws house, I was looking through “Money” magazine and saw the caption, “Make 15% interest by becoming your own bank.” Having unsuccessfully dabbled in the stock market where I was certain that Satellite Radio was going to make me my first million dollars, I read through the article and found the idea of p2p investing and enticing interest rates to be right up my alley.
Returning back to my home, I immediately set up an account and invested my first installment, $500 dollars.
What has been your biggest mistake as a p2p investor?
Perhaps my biggest mistake as a new p2p investor was not having a strategy. Early on, Prosper lenders would get to read “the story” from those asking to borrow money of why they needed it. I would read their story, look at their FICO credit score (provided by Prosper), late payment history, and any judgments and decide whether to lend any money.
You could lend to somebody with good credit that had an “A” rating, “B’ with fair to good, “C” just average credit, a “D” with poor credit and then finally “HR” or high risk. Obviously, the higher the risk, the better the interest.
HR was paying 33% interest, sign me up, I put $500 dollars, 20 different loans at $25 dollars each, what could go wrong? Being naive, I didn’t get that the reason that these borrowers are “high risk” was because more than half of them were going to default. Investing more money, losing more money, within 3 years I had invested about $400 dollars and had an ROI of -12.96%. Didn’t seem like I was going to get rich this way either.
Jeff shouldn’t be too hard on himself, beyond the rookie mistake of jumping into high-risk loans without a strategy most p2p investors saw some pretty horrid returns those first few years of peer lending. Of the 17,635 loans originated on the site to the end of 2007, nearly 39% of them (6,875) eventually defaulted or were charged-off. Investors exclusively betting on the HR category had it even worse with 63% of the loans eventually defaulting or being charged off.
The Great Recession hit p2p investing especially hard as borrowers dropped unsecured loans along with just about every other type of debt. Default rates on residential mortgages hit a high of 11.27% in 2010, more than eight times higher than the rate in 2004.
Completion on Prosper loans has done much better over the last several years. Of the 102,886 loans originated in the year to October 15th of the last year, only 383 (0.37%) have defaulted or been charged off while 699 (0.68%) are more than 30 days past due.
What has been your biggest surprise with p2p investing?
Perhaps my biggest surprise with Peer to Peer lending was how easy it was that any individual could basically be their own bank. I have just under $21,000 in my account, and all of the money has been loaned to people all over the United States.
This is a big part of why I started this site. Social lending and crowdfunding are revolutionizing the way we think about finance in America. Before now, regular people have been locked out of the market for loan and startup financing. P2p lending and investing are opening up a whole new world of capital allocation and I don’t think anyone really sees how big it could be.
In effect, through investing on Lending Club, people are able to start their own bank and lend money out to others. No longer do borrowers need to beg the mercy of bankers and no longer does the economy need to wait until banks open their vaults for loans.
Since you began P2P investing, what have your returns looked like?
From 2005-2008, my returns were a pretty ugly -12.79%. From 2009 to present, my average returns have been 11.76%. I turned my first profit late in 2009 and 2011 being my best year with an average return of 20.99%.
An annual return of 12% over six years is pretty amazing, especially considering that Prosper reports average seasoned returns of 9.3% for loans originated from July 2009 to November 2013. Those returns are nearly twice the 7.2% long-term annual return investors have seen in the stock market and well over anything in the bond market. Let’s see if we can’t get Jeff to spill the beans on how he picks peer loans.
Note: I’ve updated this post (originally published in November 2014) with Jeff’s returns including the last ten months. To November 2014 his return on p2p investing was 14% with the last 10 months bringing it down slightly. Jeff attributes the lower return to increasing his amount to each loan to $450 and losing a few more loans.
I would say it is much more a result of lower interest rates across all of p2p investing. Seasoned returns, the returns on p2p loans to November 2013, averaged 9.3% but the estimated returns on new loans are only averaging 5.7% according to Prosper.
How do you pick peer loans for your portfolio?
I try to balance my portfolio with loans from each credit category, loaning the same amount of money to each borrower. I started investing with $400 to each new loan but increased the amount to $450 at the beginning of 2015.
Jeff invests more money into each loan of his portfolio than most investors. I have seen some sites suggest investing the minimum ($25) in a portfolio of thousands of loans. You could never analyze that many loans so basically you are just throwing your money at a basket of loans based on a few criteria. Worse still, by setting your investment in each loan so low you will need to broaden your criteria to find enough loans. This means investing in lower-quality loans that you wouldn’t otherwise.
By investing larger amounts in each loan, Jeff does not need to find thousands or even hundreds of loans to fill his portfolio. He can cherry-pick the best ones that meet his criteria and does not have to worry about cash sitting in his account un-invested for too long. I would say that an investment of between 0.5% and 2% of your portfolio in each loan would probably be sufficient to keep you diversified but not too spread out.
I’ve got my own strategy for investing on Lending Club and shared three tips in a prior post.
- Take advantage of the robo-investing tool to keep your money working for you
- Don’t be afraid of higher risk loan categories but diversify across many loans
- Use selective investing criteria to boost your return and lower defaults
How has your strategy for p2p investing evolved?
My strategy for p2p investing has changed significantly since early in the beginning. Previously I focused on loans that offered the highest interest rate, not balancing my portfolio with borrowers from all spectrums of credit worthiness. I also learned that loaning money to first time borrowers is much more risky than loaning to those that have established a history/record of on-time payments and a minimum of at least one previous loan. Simply, I only loan money to those who have already paid off one prosper loan, this I have found to be the most reliable indicator of success of repayment.
There are a ton of factors by which you can sort and pick loans. No one group of criteria is the best but Jeff’s method seems to be working exceptionally well. His strict criteria for peer loans has limited his loan selection at times but has also helped him beat the average return.
P2p investing has changed significantly over the last couple of years. Whereas there were once generally thousands of loans available on the site at any one time, anymore you are likely to find less than a few hundred available. Investor money has poured in as peer lending goes mainstream and competition for loans is extremely high.
As an investor, you need to have the discipline to stick with your criteria and make fewer loans at higher amounts instead of loosening your criteria and facing potentially lower returns.
Beyond some of the more common criteria like home ownership and previous loan success, I like looking at the borrower’s occupation as well. Higher default rates are to be expected in lower paying occupations like Nurse’s Aide (51% default rate) and food service (44%) but you might be surprised to see that realtors (49%) have the second-highest default rate. You would also expect professional careers like Attorney (13%) and Doctor (18%) to have lower default rates but might be surprised that college seniors (23%) also have a relatively low default rate.
You can download the history of all loans on Prosper along with all the available criteria to uncover some pretty strong predictors of loan success.
I’ve tested some of my favorite Peer to Peer Lending Investing criteria and include a table below. The table compares the return and default on loans across six different criteria plus the info on all loans. Each p2p investing criteria is tested individually to find its effect on returns.
Best Peer Lending Investing Criteria for Higher Returns
|P2P Investing Criteria||Description||Return on P2P Loans||Average Interest Rate on Loans||Average Loss on Defaults|
|All Loans||All P2P loans available on Lending Club||7.2%||13.4%||6.4%|
|Debt-to-Income Ratio < 20% (Joint)||Total monthly debt payments relative to income for joint account loans||10.8%||13.6%||2.3%|
|Joint Application||Loan application filled out by borrower and cosigned by another||10.6%||14.4%||3.3%|
|Inquiries Last Year < 4||Borrower has applied for credit three times or less in last 12 months||8.3%||12.3%||3.4%|
|Accounts Opened Past 24 Months < 4||Borrower has opened three or fewer credit accounts in last two years||8.2%||12.6%||4.6%|
|Employment > 10 Years||Borrower has been employed for 10 years or longer||7.9%||13.5%||5.8%|
|Annual Income > $75,000||Borrower has annual income greater than $75,00||7.7%||13.0%||5.5%|
Finding loans where the borrower’s debt-to-income ratio is under 20% and where they have a co-signer seem to boost peer lending investing returns the most. It makes sense, if borrowers have less debt and someone backing their loan then they are more likely to pay it off.
Don’t just focus on the extra return on each criteria but also the default rate. Combining some of these criteria with loans in the riskier categories like loan grade C and D can really help boost your returns on fewer bad loans. You may not be able to combine all these loan criteria and still find enough loans in which to invest but play around with these six and you should see higher returns and lower defaults.
One important tip to remember is that Prosper adds loans to their database only twice a day, at 9am and 5pm on weekdays and at noon on Saturday and Sundays. All times are pacific standard. If you are able to login around those time, you stand a much better chance at finding loans that meet your criteria for investment.
What would you suggest to borrowers who are trying to get a peer to peer loan funded?
For borrowers, it’s always smart to start out with a small loan, like in the $3,000 dollar range, pay that loan off over a period of a year or two, and then apply for a bigger loan the second time around. Lenders like to see an established payment history with large loans (all the way up to $35,000) having a much greater chance of being funded.
What should investors know about the risk in p2p investing?
Risk in p2p investing definitely exists. Presently I have had 104 defaults in about 721 loans. However, more than 70 of these defaults happened prior to 2009. Defaults have picked up a little this year as I’ve invested in more loans but are still averaging less than 20 per year.
Jeff’s story again speaks to the severity of the financial crisis and the importance of a good strategy in selecting loans. A screenshot he provided lays out a good portfolio with 111 active notes, of which 104 are current and only five are more than 30 days past due. Loans more than 15 days overdue are sent to a collection agency which attempts to collect the past due and put the borrower back on track. Jeff tells me that he is seeing about 30% of those borrowers eventually return to payment status.
The number one question I get about peer loans is the risk involved. There are risks but then all investing is inherently risky. Investors lost more than half of their portfolios in the years leading up to the stock market low of March 2009, yet few really question the need to hold stocks over the long-term. It is the same with peer lending and p2p investing. There are risks but there are also ways to minimize those risks and the returns can be great over a period of many years.
More than understanding the risks involved, p2p investors need to understand their own tolerance for risk as well. If just the thought of one of your loans defaulting makes you squeamish then you should probably avoid all but the highest-rated loans. If you can sit back and understand that even if a couple of loans default, your diversified portfolio will still do well then you can pick from the lower-rated classes.
How do you see your returns for p2p investing going forward?
My returns going forward will likely average between 10% and 12% a year. Prosper has done a much better job of vetting borrowers with accuracy of credit reporting, debt-to-income ratio, years of employment and other criteria. There are less borrowers with High Risk credit getting loans, now requiring a FICO score of 640 or higher. To date, I have made $10,576 in interest so I consider the whole experience to be a good one. Of the roughly $3,600 that I have seen charged-off on bad loans over the period, only $1,600 has been charged-off over the last five and a half years.
Your own returns in p2p investing are going to depend on what level of risk you are willing to take and from which credit ratings you select loans. Develop a working strategy based on historical data and you should be able to earn a return of 10% or better on a diversified portfolio.
A lot of p2p investors have asked me what will happen to peer lending borrowers and their p2p investments when the next recession hits. It’s a good question, especially since the last recession ended more than six years ago which is relatively long for a business cycle.
Default rates will increase on p2p loans when the economy turns lower, there’s really no avoiding that. I still think p2p investing will provide for higher returns than stocks and traditional bonds though because of the credit quality of most peer borrowers. Prosper does not allow subprime lending and the average borrower has a 706 credit score.
Good credit borrowers will be less likely to lose their job or find themselves in a dire financial situation where they would default on a loan. Even if the average default rate shot up by 50%, average p2p investing returns would still be 4% which is above the return on most corporate bonds. The return on p2p investing will be well above the likely negative return on stocks. Of course, it depends on the type of recession and the severity.
Open your own bank for monthly income – Click to get started on Lending Club
I want to thank Jeff for sharing his secret to p2p investing and his experience in the new asset class investment. Lending Club is the largest p2p lender in the world and my preferred platform for peer lending investing for its ease of use and features. There are still risks around peer investing just like any investment but the strategy is quickly becoming my favorite for increasing returns and reducing risk around my stocks and bonds.