I've written several posts about my foray into Peer-to-Peer Lending via Lending Club and Prosper, and in the past few weeks I've read several (probably sponsored) articles encouraging people to invest via these platforms. After reading a bunch of blog posts several years ago, investing some money on these platforms seemed like a good idea. Now, after about three years, I am in the process of withdrawing my money and I do not advise anyone to put their money into these platforms. Why?
The Reward Does Not Compensate for the Risk
Bank accounts don't pay much, but you know you aren't going to lose money. You can lose everything investing in the stock market, but you can also double or triple your money, or more. The upside of bonds is limited, but the risk of your investment being worthless can be limited by investing in high-quality bonds. After investing via Lending Club and Prosper for three years, I have no trouble saying that the rewards do not compensate the average investor for the risk being taken.
Both Lending Club and Prosper warn investors to expect defaults--that's the nature of unsecured loans. Some people will pay them; some people will not. The unfortunate fact is that lenders have to make enough money off those who do pay to compensate for those who do not.
At different times, the overall default rate increases or decreases due to the overall economic health of the country. When times are bad, more people lose their jobs and when people lose their jobs, unsecured loans are the first payments skipped. The rates charged for loans have to consider not only what the rate is likely to be today, but what will likely happen if the economy tanks. I'm not earning enough today to convince me that I wouldn't lose money if the economy tanks. Too many people are defaulting now--in April my average balance with Lending Club was about $9,200 and, after defaults, I earned $6.89. Since unemployment is low and the economy is basically doing well, I have to believe I'd lose money if we move toward a recession.
Lending Club publishes statistics about its overall portfolio and about what returns can be expected. You can see them here. When I started investing via Lending Club, the norm from which it was hard to stray if you had a reasonable sized portfolio was about 8%; now it is about 5%.
Before investing via Lending Club and Prosper, I did my homework. I read articles. I read the statistics on their websites. Everything was showing average returns in the 8% range. With returns in good times in that range, I figured there was room for some defaults in bad times. Then something changed. Interest rates went down and underwriting standards were made less stringent, which resulted, of course, in more defaults.
The big difference between Lending Club and your local bank or payday lender is that the bank and payday lender are loaning out their own money. If you don't pay back your loan, they lose money. If a Lending Club borrower defaults, Lending Club doesn't suffer the loss, the investors do. Lending Club makes their money via origination fees and via service fees (they take a small percentage of each loan payment). It is in Lending Club and Prosper's best interest to facilitate as many loans as possible.
There are two ways the conflict between investors and the platforms comes into play. First, as noted above, is when the platform lowers interest rates or credit qualifications in order to increase loan volume. The second is when the platform solicits current borrowers to refinance loans at a lower rate. The platform gains an origination fee. The borrower (hopefully) saves money. The investor loses because the high-interest loan is paid off early and therefore with less interest. Also the 1% service fee on the lump sum repayment can consume several months interest.
Lack of Knowledge
I am not an expert on underwriting loans. As a matter of fact, I know very little about it. When loans are offered on Lending Club and Prosper, certain data points are made available to investors, but I lack the ability to analyze that data to determine in the offered interest rates are sufficient. Banks and their computers do not have that problem, and more and more of the loan volume on Lending Club and Prosper are being purchased via computer by institutional investors. I have a hard time believing those computers will not skim the cream of the loans, and I can't even identify the cream.
You used to be able to find blog articles about "filtering" Lending Club or Prosper loans--searching the offered loans for those meeting certain criteria that historically (short as "history" was) had done better than average--and then purchasing those loans. NSR Invest offers a tool that allows you to back-test your strategy--to see if filtering out certain loans or looking for others would have increased your return on investment IN THE PAST. The problem is that Lending Club and Prosper can (and do do change the rules at any time. Unless you have a very good understanding of how the criteria for rating loans now compares to the criteria used in the past, you can't use a back test tool to do anything except to see what might have happened in the past.
My experience with Peer-to-Peer Lending has convinced me that loaning money to other people is a business best left to those with expertise. Do you agree?