In a world of zero percent interest rates peer to peer lending can look mighty tempting for yield hungry investors.
Don’t be deceived. Your investment profit is determined by mathematical expectancy (most simply understood as probability times payoff). Expectancy=(Gain on a Winning Bet * Probability of Win) + (Loss on a Losing Bet * Probability of Loss).
When filtered through that lens the problems with peer to peer lending are immediately obvious:
- Your gain is strictly limited to the interest rate; whereas, your loss can be 100% creating a negative risk/reward ratio.
- Your probability of gain or loss is impossible to define because the system is too new to have been adequately stress tested.
Simply put, if you are playing the peer to peer lending game from the investor side then you are gambling – not investing - because you are working with an unknowable and potentially unfavorable mathematical expectancy.
I wish I had written the following peer to peer lending review myself but Doug Nordman of The-Military-Guide.com beat me to the punch with a well researched three-part analysis of peer-to-peer lending. Rather than re-create the wheel I asked him to boil his series down to a useful “consumer’s guide” explaining the various issues you must consider as a smart investor when looking at peer to peer loans.
Take it away Doug…
What is Peer To Peer Lending?
Peer-to-peer lending brings crowd-sourcing to unsecured loans between individual lenders and borrowers. P2P company websites greatly reduce the transaction costs of getting a loan, allowing borrowers to enjoy lower interest rates. Lenders can diversify their own risks and achieve higher interest rates than currently available on CDs or money markets.
On the surface it sounds good, but before you leap into P2P lending you need to be aware of the issues with the companies, their marketing strategies, and the lender’s poorly-understood risks.
Yes, it’s true that many borrowers have paid off their debts with P2P loans, and some individual lenders have built up six-figure portfolios earning double-digit returns. However in the last year too much money has started chasing too few loans through companies that are struggling to grow their business.
Let’s start with the dangers faced by borrowers.
A P2P lending company seeks borrowers with credit scores as low as 600, but usually at least 660. Borrowers apply for unsecured loans of $1000-$35,000 for 3-5 years at APRs as low as 7%. (Borrowers with lower scores, or with high debt-to-income ratios, will pay APRs as high as 35%.) The P2P company websites verify ID and run a credit check but do not always verify a borrower’s income or other debts. Their risk committees use proprietary software to assess a loan’s default risk and set its interest rate. Borrower’s anonymous loan applications are posted on the company’s website for lenders to bid on.
When lenders have agreed to fund the loan, the P2P company has the borrower sign a promissory note in exchange for the funds. (The P2P company takes an origination fee of 1%-5%.) The P2P company holds the promissory note and services the borrower’s loan payments, distributing them to the lenders (for another 1% fee – are you noticing a pattern of the high fees involved?).
The company assesses penalty fees for late payments. If the borrower stops paying then the company adds on more fees and eventually declares the loan in default. Since the loans are recourse debts with no collateral, the P2P company can report the default to a credit-reporting agency, sell the note to a collection agency, and obtain a court judgment against the borrower.
Most borrowers want to consolidate their credit-card debt at a lower interest rate. Others with poor credit want to start a business, renovate their homes, or even pay for a wedding or a vacation. ( More details are discussed at The-Military-Guide.com ).
The P2P companies use the same marketing tactics as the credit-card industry and payday loan businesses to encourage borrowers to keep taking loans! The P2P websites are very easy and fast and the approval process is much quicker than traditional loans. The companies offer enticing stories of customers paying off their debts (at lower interest rates) and living the lives they deserve, thanks to the crowds of eager lenders who are happy to help them achieve their dreams.
P2P companies encourage borrowers to indulge in thoughtless spending. Even if borrowers consolidate credit-card debt and lower their interest rates, it still doesn’t help them change the habits that got them into debt in the first place. Debt is a personal problem of spending more than you earn, and a P2P loan won’t help you change your overspending habits.
In short, P2P programs are a band-aide that treats the symptom of a debt problem rather than the underlying cause of the debt problem.
Lenders use a P2P company’s website to screen loan applications and build a diversified portfolio of loans at higher interest rates than can be earned elsewhere. The carrot is convenience and interest rate.
Lenders can diversify between high-quality loans with low interest rates or riskier loans with much higher interest rates. The low-interest loans are predicted to have low default rates and the risky loans are expected to have much higher default rates. Investors can analyze the P2P company’s extensive database of loans and payment histories, but they can’t review the risk committee’s decisions on interest rates or analyze their proprietary software. Investors are encouraged to diversify by investing small amounts in hundreds or thousands of loans.
Lenders can use the P2P company’s selection software or build their own filters. A number of blogs and third-party vendors supply even more analysis tools to let lenders sort through databases of tens of thousands of applications. The P2P companies are expediting this process with automated features to “help” lenders choose loans and invest more quickly (for a small additional fee… again). Some of these services cater to their institutional customers and others are rolled out to their individual lenders.
Most individuals invest $5000-$25,000 @ $25-$100 per loan. (Financial companies and institutional investors build much larger portfolios for their own clients.) Once a lender takes a portion of a loan, their money is deducted from their holding account and they’re assigned their share of the (anticipated) payments for the next 3-5 years. The P2P company holds the borrower’s promissory note and distributes monthly interest/principal payments, deducting a 1% servicing fee. Lenders are also entitled to late fees, but if a loan goes into default then the P2P company may keep additional fees & penalties to offset their collection expenses. The few loans that lapse beyond 30 days are only brought current by borrowers about half the time, and the other half are eventually are declared in default.
Default rates range from 2%-4% on the “best” loans, but default rates for high-risk loans can exceed 10%. Investors accept the risks of unsecured lending just like credit-card companies, only at lower interest rates than card companies. Lenders have to analyze thousands of loans to avoid those likely to default– or else trust the company’s automated tools. A well-chosen portfolio of risky high-interest loans can earn returns above 15% after defaults.
P2P loans have terms of 3-5 years which means actual returns are unknown until the full portfolio of loans has matured and paid off (or defaulted). Until that date your assets face liquidity constraints. There is a small secondary market on FOLIOfn, but most are sold at a discount. Sellers may need several weeks to sell their loans at par (minus the 1% transaction fee). During a recession there may be no market at all for these loans, and the loans still have a default risk.
The Lure of High Returns
Unfortunately many lenders are distracted by the high returns and fail to properly assess the risk.
When you loan money through a P2P company, you can’t tell whether you’re getting paid enough for the risks that you’re unwittingly taking. The interest rates are set by the companies using proprietary software that estimates default rates from history. Unfortunately the major American P2P companies, Lending Club and Prosper, have been in business for less than a decade. There’s no indication that their default estimates will be accurate during an economic downturn. During 2007-08 some of their default rates soared (in one month by over 30%). Even worse, both companies spent much of the Great Recession on the sidelines pending regulatory approval of their business model, so their latest algorithms have never been tested during a real economic decline. Their current portfolio history is barely longer than their five-year loans.
(Editior Note: If you are thinking of lending money peer to peer then read that last paragraph again. It is absolutely key. The risk of loss has not been adequately defined but anecdotal evidence is unfavorable. This undefined risk of loss will determine the mathematical expectancy of your investment.)
An investment portfolio has to balance risk and reward. Mathematical models can’t faithfully reproduce reality, especially during extreme bull & bear markets, so results will vary from predictions. Nobody complains when returns are higher than expected, but everyone is unhappy when returns are lower. Asset allocation and diversification can limit the damage of a black swan event, but the math can’t predict when it will happen.
Even worse, a P2P lender’s return is limited to the interest rate. Even if every loan is paid on time, lenders can only receive the rate set by the interest committee (after fees). Lenders can’t tell whether they were adequately compensated for their risk, or whether they just got lucky.
Nobody knows what will happen to loan default rates during a recession or a credit freeze, but those incidents were highly destructive in 2008-09. P2P lenders could have years of good returns before disaster strikes. It’s like driving without seatbelts: nothing bad happens for years and you conclude that the risk is small. However when a crash inevitably happens the result is devastating, and there’s no collateral or insurance for your capital at risk. Stocks may recover and even defaulted junk bonds may eventually repay 30% of principal, but defaulted P2P loans almost never pay off. The P2P lending companies will keep any funds recovered by the collection agencies or the courts.
Even if lenders build a diverse & conservative portfolio, it’s still difficult to distinguish luck from skill. Financial planner Jason Hull demonstrates that a statistically rigorous loan portfolio can require over $180,000 (over 7200 loans @ $25) to be confident that returns will match expectations. The P2P companies advertise that “breaking even” requires a portfolio of at least 800 loans (at least $20,000). Few lenders will take the time & effort to screen tens of thousands of loans for those portfolios, let alone have the capital to invest in becoming skillful rather than lucky.
Unfortunately Lending Club and Prosper aren’t making money for their own investors, let alone spending more on better mathematical models. Instead of getting rich from their own loans, they’d rather get rich collecting fees from servicing the loans.
Both companies are successful startups (by Silicon Valley standards) but neither is profitable. Lending Club has had at least one quarter of positive cash flow but Prosper recently narrowly averted a brush with bankruptcy. (Prosper raised $20 million at a huge discount to their share value, and then replaced the board of directors as well as most of their executives.) Their financial survival rests on making as many loans as possible with as little expense as possible, and both companies are struggling to scale for growth.
The pressure to cut expenses and move faster could also tempt them to overestimate returns and cut corners. Both companies inflate their lender’s returns by assuming that funds are reinvested instead of distributed. Claims are based on estimated loan durations and projected default rates. Both Lending Club and Prosper delay declaring a loan in default for months after the borrower has stopped paying it. Corporate and institutional investors are starting to pour millions of dollars into P2P loans, putting further pressure on the approval process. An application is essentially just a FICO score and a credit check with verification lagging far behind. (Lending Club attempts to verify a borrower’s stated income on about 60% of their loans, but this takes several days.) Loans are purchased less than 48 hours after they’re posted, and retail P2P lenders are getting crowded out as too many dollars are chasing too few loans.
Will these companies survive? After 7-8 years it looks like the answer is “probably”. More importantly, if either one goes bankrupt then their loans are protected. Borrowers will still be required to pay, and backup companies are under contract to take over the loan processing. Lenders should still get paid as long as the turnover goes smoothly. However this is a new business model that’s never been tested by a large-scale bankruptcy, and there’s no guarantee that borrowers will continue to pay back their unsecured loans to a bankrupt processor. There could be days or even weeks of confusion and uncertainty before loan servicing returns to normal. If you’re a P2P lender then you have to factor the risk of “frozen accounts” into your plan and decide whether you’re being adequately compensated.
Your Weaknesses As A Lender
Lending Club and Prosper both use sophisticated marketing tactics to distract customers from the unpleasant realities. As soon as you land on their websites, you’re tacitly lulled into a number of investor behavioral-psychology vulnerabilities. Borrowers are already familiar with the myth of “You deserve to live your dreams with our loans!” put out by so many credit-card companies.
Research shows how investors use heuristics and biases to make their decisions. We claim to be logical and rational, but our mental shortcuts and emotions interfere with our decisions. The P2P companies are keenly aware of these tendencies– and they exploit them.
Their most blatant tactic is the illusion of control. You’re fooled into thinking that your hard work pays off. You’re using a sophisticated website (or third-party tools) to filter thousands of applications and dig into all sorts of obscure criteria. Meanwhile you have no idea whether the data is valid (or even truthful) and you’ll never know whether your return justifies the risks. Most lenders don’t invest enough funds to distinguish luck from skill, but they’ll credit their skill for their success.
The P2P companies also stress their affiliate marketing. Both borrowers and lenders feel like members of exclusive clubs, with teams of people helping each other. Lenders can get credits for investing or for referring their friends. Lenders are warned that they have to qualify to understand the rules and the risks, yet the company disclosures & disclaimers make the entire process look like an exciting and attractive way to earn high returns.
The social proof encourages you to join the crowd to get in on a great deal. The artificial scarcity and a sense of urgency only make you feel obligated to move faster, before all of the good loans are taken by smarter lenders. The companies will even automate the process (for a small additional fee) and all we have to do is keep adding money. You’re part of a select group of smart people helping other people. You can afford to join the club, and there’s no need to keep working so hard when you can just sit back and enjoy the streams of passive income.
Worst of all, however, is the lender’s temptation to chase yield. They’re encouraged to pull their money out of CDs, money markets, and bonds to invest them for greater returns.
Should You Be A Peer-To-Peer Borrower Or Lender?
P2P loans don’t solve the root problem that got borrowers into debt in the first place: spending more than they earn. Even worse, borrowers have to pay an additional 1%-5% fee. While a P2P loan gives borrowers a lower interest rate, they can still do better on their own. Borrowers can pay their debts even more quickly by making lifestyle changes to cut expenses and accelerate payments. Rather than paying fees to a P2P company to borrow they could use that money to get out of debt.
Lenders are also seduced into a sense of false security. Before you give in to their marketing tactics and start chasing yield, please understand that nobody knows the real risk of the loan defaults. You have no idea whether the future will resemble their brief historical records (especially during a recession) and you have no idea whether you’re earning enough yield to compensate for that unknown risk. The P2P companies are already overstating the returns and understating the risks, while you’re simply putting money into an unsecured loan for 3-5 years with limited liquidity.
This is not investing. At best this is speculating, and at worst it’s legalized gambling. If you must engage in P2P lending, do it only with funds that you can afford to lose– and regard it as an entertainment expense rather than an investment.
Author Credit: Thanks to Doug Nordman for sharing his well researched insights in this peer to peer lending review. Doug is a retired U.S. Navy submariner and the author of “The Military Guide To Financial Independence & Retirement“. The book shows servicemembers, veterans, and families how to achieve their goals on their terms, and more than 50 others shared their stories to explain the simple techniques. All revenues from his writing are donated to military charities.
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