Managing a peer to peer portfolio effectively requires experience, skill, and time.  There are a number of investors intrigued by peer to peer lending, but simply don’t want to do the legwork of reviewing borrowers credit and investing tiny chunks of their portfolio into many different loans.  This is particularly true for investors looking to put a significant amount of money into their account.  The time to get the portfolio fully invested and then the ongoing maintenance in keeping it fully invested can be quite demanding.  The good news is both Lending Club and Prosper offer solutions for investors looking for a more passive p2p lending option.

Lending Club PRIME

There are two types of accounts at Lending Club, standard and PRIME.  The main difference is with standard the investors personally invests all of their money on the platform, whereas with a Lending Club PRIME account the money is automatically invested.  Investors specify a desired loan interest rate to target and tell Lending Club whether to reinvest the payments made on the loan.  Investors may choose over time to personally begin managing their reinvestments if they want to take control of the account.

Lending Club PRIME accounts are only available to investors opening an account funded with at least $25,000.  There is a one-time fee for the service, which is 0.8% charged when the money is transferred into the account (so a minimum of $2,000).

Prosper Premier

Prosper just announced today that they will be offering a passive account, dubbed Prosper Premier.  Investors tell Prosper the loan grade and note term target allocation, maximum amount per loan to manage level of diversification, and whether to automatically reinvest. Premier accounts have a fee of 0.8% charged when the funds are invested, but according to Social Lending Network, for a limited time this fee will be waived.  The minimum account will also be $25,000.

These types of accounts can be a great way for investors to get their portfolio fully funded, giving them the option to take the reigns at a later date, if desired.  Lenders can also monitor the performance of the loans over time and get a hands-on feel for the specific types of loans that they may choose to avoid in the future.

The number of credit inquiries in the last six months on a borrower’s credit report has a strong correlation to the likelihood of loan default.  Using this simple filter when investigating loans, an investor is able to make significant improvements in the performance of their loan portfolio.

The number of credit inquiries represents the amount of times a business has requested a borrower’s credit report over the last six months.  When an individual is requesting their own credit report, that is considered a soft inquiry and does not affect this number.  The number is affected only when a perspective lender requests the borrower’s credit report, which is considered a hard inquiry.  However, if the borrower attempts to shop the best rate when buying a car or home, that activity is automatically detected and the multiple inquiries are treated as a single inquiry.

Using LendStats, when looking at all loans issued through Lending Club since 2010, 2.71% of all loans have resulted in default.  You can see in the graph below, the dramatic improvement to the default rate when applying a maximum number of inquiry filter of 2, 1 and then 0.  Additionally, LendStats shows the overall performance of Lending Club loans where no max filter is set is 7.03% and one with 0 max inquiries is 7.86% ROI, a 0.83% improvement.

Lending Club Max Inquiries and Rate of Default

According to their public filings, Lending Club limits the number of inquiries a borrower can have on their credit report to qualify for a loan.  Borrowers with a high credit score can have a maximum of 8 and those with a score lower than 740 can only have 3.  This number is even used to determine the interest rate offered to borrowers.

Performing the same analysis on Prosper data we see similar improvements when adding filters for maximum number of inquiries.  Prosper’s unfiltered portfolio of loans has a default rate of 4.58% with rate of return of 9.06%, whereas a portfolio of loans with 0 max inquiries has a default rate of 3.74% and 9.78% ROI, a 0.72% improvement on ROI.

Prosper Max Inquiries and Rate of Default

Filtering for max number of inquiries when searching for p2p loans is one of the most basic and effective ways to improve your return on investment.  Be sure to include it in your criteria when evaluating loans.

When posed with the idea of loaning money to strangers as a way to invest, many people’s immediate reaction is that the idea is too risky.  They are afraid of being scammed out of their money.  Engaging in business with others takes a lot of trust, and as much as it seems that peer to peer lending is a social engagement, lenders really know very little about borrowers.

Lending Club vets the pool of potential borrowers down to a smaller set of qualified folks.  Each borrower’s identify is verified, by ensuring that all borrowers submit a social security number and other identification card, such as driver’s license.  Lending Club cross checks information provided with the borrower’s credit history.  Employment and income information is asked of the borrower, but not always verified.  An icon is displayed on the loan listing next to these fields when the information has been verified.  According to Lending Club’s 10-K filed in March 2011, 61% of borrowers had their employment and/or income information verified, which included submission of pay stubs and tax forms.  Home ownership status is also requested, but not verified.

A combination of the borrower’s credit score and other information from their credit report result in the loan being classified within a certain loan grade and sub-grade, along with an interest rate.  Borrowers must have a credit score of at least 640 to be considered for a loan.

Borrowers are required to link their LC account to an external banking account, which aids in identity verification and is used to make monthly payments against the loan via ACH transfer.

Even with these measures are taken, scammers and other unseemly borrowers may squirm their way through the vetting process.  Lending Club investors used to be able to ask borrowers questions through loan listings to get more details on their income, expenses, or other questions relevant to their qualifications for repaying the loan.  However, Lending Club made a change in April 2011, so that lenders can only ask questions by choosing from a canned list of preset questions.  Lending Club said this was done to protect borrow privacy and identity, but some lenders found this limitation an unfair limitation on their ability to evaluate potential borrowers.  But, since the answers aren’t verified, it doesn’t seem as if this decision really made that much of a difference to assessing creditworthiness.

Purchasing loan notes on the secondary market through FOLIOfn can be a good way of investing in loans with a proven track record of previous payments.  While searching for notes on FOLIOfn, you can specify the amount of payments remaining.  You can see in the graph below, showing Lending Club Defaults vs. Age, that loans historically have defaulted earlier in their payback period.  Statistically, the possibility of default begins to decrease steadily approximately 8-10 months after origination.

Total Loan Defaults vs. Age from Nickel Steamroller - nickelsteamroller.com

As always the best way to avoid having your investments eroded by scammers and deadbeats is to diversify your lending portfolio.  Don’t overexpose yourself to individual borrowers and spread the risk across as many as you can.

Peter had a post today on Social Lending Network titled An Apples to Apples Default Rate Comparison about P2PXML, which is an attempt to standardize p2p loan data.  According to p2pxml.com, a standardization rating system can be derived using rate groups, described as follows:

Rate groups are a way to group loans by interest rates. The formula used is: RG = 1 + (floor(interest rate) / 2). When comparing platforms the grades do not translate. Since the interest rate is theoretically supposed to represent the risk of a note, it makes sense to compare platforms base on the concept of a rate group.

This is supposed to allow investor to compare apples to apples when looking at types of loans across platforms since the credit grading system differs on each one.  I’m not sure I buy the assumption that rate groups are the best way to standardize this comparison.

A few months ago I applied for a p2p loan with both LC and Prosper. LC offered me a 8.99% rate, while Prosper offered me a 6.49% rate. Using this model, my exact same loan would be compared in different P2PXML rate groups.  The interest rate is the price the platform believes will satisfy borrower and investor expectations. I’m sure those rates vary at any given time according to the platform’s desired growth rate, supply of loans from borrowers, demand from investors, etc.

Let’s pretend for a moment that interest rate alone represents a fully comparable, cross platform risk rating. What would it be that a p2p platform would do when servicing a loan with the same level of risk to cause or prevent default?  I suppose it would come down to the diligence of their collection processes.  That seems like a tricky thing to measure.  However, if we use rate groups as a comparison of pricing models, a platform’s ability to properly match loan risk to an interest rate, by analyzing default rates across platforms sold at the same rate, the analysis would be much more telling.

Remember, these platforms don’t make money directly from the interest rates on these loans, they make money on servicing the loans – underwriting, collecting and distributing payments, and performing collection duties.  They have to set rates reasonably to keep their investors (and regulators) happy, but ultimately their job is to sell services.

To get an apples to apples comparison, you would have to compare the source data, which would be the borrower’s qualifications and requested loan reason, payment schedule, and amount, etc. The same information from the borrower that LC / Prosper used to grade and price the loan.  Then, use that info to come up with a new, standard grading system.  You’d almost be rewriting the underwriting model.  That’d be a tall order, and I’m not sure how that information would change my investment behavior.

The most effective way to judge the performance of each platform is to do just that – compare the ROI of each marketplace’s entire portfolio and compare your own ROI on each platform.

Short-term debt should be paid off before investing in unsecured loans such as peer to peer lending.  This is especially true of someone with high interest credit card debt.  When looking at an investor’s overall financial picture, the potential interest earned from p2p lending would likely be negated by the interest paid to the credit card company.  Additionally, extra payments on that debt would provide a guaranteed rate of return, compared to the volatility of investing in p2p lending.

Probably one of the worst choices would be taking out a loan and investing the money in peer to peer loans, trying to profit from the difference in interest rates.   This is also know as arbitrage.  The potential ROI in this scenario is very slim, especially when you consider defaults, fees, and taxes.

For individuals holding long-term debt, such as a mortgage or student loans, the decision gets a bit more debatable.  Holders of student loan debt can be given extra considerations on government loans if they face financial hardship, minimizing the risk of holding this type of debt.  Depending on income level, a portion of student loan interest paid can be used as a tax deduction.

Mortgage borrowers enjoy tax deductions on interest paid and are also able to secure loans with very low interest rates.  For most individuals, a mortgage is the longest term loan they will ever hold.  It is also typically their largest monthly debt obligation.  While in the past mortgage borrowers felt comfort in believing they were getting leverage against an appreciating asset, over the last few years many have realized that this in no guarantee.  So, to hedge against being upside down on your mortgage loan, it would be a good idea to have at least 20% equity in your home before investing in peer to peer lending.

Cash flow is a critical factor when considering risk of bankruptcy.  Most people hold some type of debt payable on a monthly basis and rely on their monthly income to make the payments.  If something happens to that income (ex. lose job or get sick), they become cash flow negative, have to dip into savings, and either end up correcting the issue (ex. get new job or become well) or default on their debt.  Minimizing monthly debt obligations minimizes this risk.

A sound guideline would be to have no personal debt other than possibly student loans and a mortgage before investing in p2p lending.  If you hold these types of debt, when planning how much extra money you have to contribute to investing, consider diversifying that extra cash by putting a portion of it towards making extra payments against the outstanding principal.

When thinking long-term, most of us would agree that at some point we would like to retire and no longer work full-time.  Reducing the demands on your income stream is vital to realizing that goal.  Monthly debt obligations not only add risk, but are burdens to your financial freedom, making you work longer in life.  A great financial position to be in for retirement would be to have no personal debt, while receiving regular monthly payments from your investment portfolio.

Ten years ago I decided to learn to ride a motorcycle, so signed up for a weekend riding course to get my motorcycle permit.  As a new rider, my number one focus at the beginning was the same as when I first learned to ride a bike – not to fall.  Usually when a rider stops struggling with the bike and things start to click, they have quit letting their fear of falling take over, and are able to focus on maneuvering the bike properly.

Over the weekend, I talking to some of the experienced riders to try and get their take on the real risks of riding.  They all gave me a common response, which I found a bit surprising – it is not a matter of if you will fall, but when you will fall.  The first few times I heard this I uncomfortably chuckled, thinking these guys must be kidding.  But, eventually I realized they were serious.  The risks are real and these folks have accepted the risk.  In their minds the benefit, their enjoyment of riding, is worth the risk of injury.

With peer to peer lending you face a very similar situation, thankfully without the bumps and bruises.  It is not a matter of if you will have a borrower default, but when you will have a borrower default.

No matter how much research you do into finding just the right metrics on credit reports, what to look for in loan listing descriptions, and other risk mitigation techniques,  you will eventually end up with a borrower who falls behind on payments.  Of course, if this wasn’t the case, the potential returns would be much less.  Unsecured consumer loans, such as peer to peer loans, are offered to borrowers at interest rates in line with the investment risk experienced by the lender.

I often run into blog or forum posts where someone has experienced their first default.  Usually they are ranting, throwing their hands up in disgust, ready to quit peer to peer lending.  Like any investment, you need to have realistic expectations.  Thinking you’ll never experience a deadbeat borrower is fantasy.

Here is why you should put the fear of default aside – a lender’s objective shouldn’t be total risk avoidance.  That’s like searching for Bigfoot.  Instead, the goal is to find the optimal zone where the loan interest rates minus the rate of default equals the greatest rate of return.

Looking at the top 3 Prosper lenders by rate of gain on LendStats, each are enjoying greater than 18% ROI, after taking into consideration their average rate of loss of 6.4%.  The loans they are investing in have an average interest rate in the mid-twenties.  So, the math looks something roughly like this:

25% IR Loan – 6% Rate of Loss – 1% Fees = 18% ROI

They have found loans with high interest rates, below average rates of default, which provide them an optimal rate of return.  They accept the mantra – it isn’t a matter of if the default will occur, but when.  They have found the acceptable rate of default for their portfolio and are able to experience above average returns.

Failure is always coupled with an opportunity for learning.  Thankfully, in this case we can learn from someone else’s failure to hopefully avoid it ourselves.  The Prosper.com lender we’ll look at goes by the nickname warew, who according to LendStats ranks as the top lender by rate of loss by posting a return on investment of -14.71%, losing over $2,000 in the process.  Ouch!

Warew lent $15,831 on 89 loans, making his average investment per loan a whopping $178.  This immediately sends up red flags, clearly this lender did not diversify properly.  There is very little reason for someone with this amount of money invested to put any more than the minimum amount of $25 into a specific loan.

The story actually gets worse when digging through the transaction details.  Just two loans make up 76% of this lender’s entire portfolio, totaling $12,008, one of which is currently in default.  Both are business loans, which carry a higher risk of default.  Here are the loan details for these two:

• Loan 512039
• IR:  31%
• Bid:  $6953
• Origination Date:  06.28.11
• Description:  Nurse & Police Officer Need You!!
• Status:  Current
• Loan 494950
• IR:  23%
• Bid:  $5055
• Origination Date:  05.27.11
• Description:  Police Officer Needing 911 Help
• Status:  Default

I find it interesting that both of the descriptions include police officers asking for help from their fellow citizens.  My assumption is that these descriptions were a motivating factor in driving our lender to action.

There are three lessons I see from this quick overview:

1. Beware of loans that are being requested for business reasons
2. Diversify your p2p loan investments, only putting down the minimum $25 on any one loan
3. Do not get caught up in emotional calls to action in the loan description

I actually found sifting through this lender’s data a bit depressing.  You can really tell this is someone who cares about other people and is trying to help borrowers out with these loans.  But, it is clear loan investing should not be based on emotions if your goal is to make a positive return on your investment.  I wish warew the best.

Obtaining a business loan has been increasingly challenging since the financial crisis in 2008.  Banks have become more hesitant to lend, putting a pinch on small businesses trying to seed their growth by using debt.

Because of the banks unwillingness to lend, many small business owners are turning to private business loans instead.  One of newer options available to borrowers is peer to peer business lending, an appealing way for small business owners to obtain an unsecured loan.

When a business is in its infancy, the enterprise typically does not have a credit rating of its own.  Therefore, it is common for the entrepreneur to personally apply for the loan and lenders rely on their credit rating to evaluate the investment.  This poses some challenges when evaluating the loan since the money isn’t being borrowed for typical individual use, such as paying off credit cards.  And, of course, many new small business fail pretty soon after starting up.

But, the idea of funding someone’s dream of starting a business can be appealing to lenders looking to make a difference.  Stories of successful entrepreneurs are amazing and inspiring.  While all of us can root for the success of these young enterprises, a prudent investor must analyze the performance expected from this type of loan.

In fact, statistics show that investing in these types of p2p loans can be extremely risky, and the historic returns of investments are low.  According to LendStats, small businesses loans through Lending Club have only provided a 1.78% return to investors, with nearly a 10% rate of loss.  This is based on 1,908 loans originated worth a total of $26,846,255.  For small business loans at Prosper, investors have seen a better ROI, 7.39%, with a similar rate of loss at 9.74% on 2,364 loans totaling $17,501,134.  The difference in performance being that the average rate on these loans at Lending Club has been 13.7%, while being 20.5% at Prosper.  Additionally, the average loan size of this type is approximately $14,000 at Lending Club, but only $7,000 at Prosper.

Investors should consider the unique risks of investing peer to peer business lending when evaluating notes for their investment portfolio.  Historical statistics show that these types of loans have not performed well.  If in the future these loans were adjusted to investors at higher rate to account for these risks, they may become more appealing.

I received a nice email today from Lending Club congratulating me for earning a net annualized return (NAR) of 14.23% for my first 3 months of investing.  The NAR calculation, as described by Lending Club, is as follows:

Net Annualized Return is the output of a formula where the numerator is composed of interest received, plus late fees received, minus the 1% service charge paid.

It is interesting in their email text that they specifically say the loans will pay out over three years.  There was a recent post on SocialLending.net about Lending Club nudging investors away from their 5 year products.

Checking LendStats for comparison, my ROI is 12.3%, taking approximately a 1% hit on a few notes in Grace Period.

Based on my analysis with Nickel Steamroller’s Analyze My Portfolio tool, there are definitely a few notes that I should sell because of overly conservative plays (less than 10% IR) made when I was first building my portfolio.  So, I’m fairly confident that I can improve on this number over time as long as I don’t run into an inordinate amount of defaults.  I’m also being diligent about reinvesting the payments I receive to keep my money constantly working.

Overall, I’m satisfied with the performance of my investments with Lending Club and look forward to continuing to learn ways to improve my returns.

As your Lending Club portfolio grows, it becomes increasingly difficult to manually manage all of your notes.  Nickel Steamroller’s Lending Club portfolio analysis tool helps ensure your portfolio is well appropriated, looking for things like multiple notes associated with the same loan, less than average interest rates, and late loans.  When it finds these outliers, it makes recommendations on selling the notes on FOLIOfn.  It also provides you performance metrics, including ROI by the specific portfolio you assigned them to in the notes section.

Interested in seeing the recommendations for one of my own accounts, I gave the tool a whirl.  First off, similar to LendStats, first you need to go to Lending Club, switch over to the Notes section of your account and click Download All in the lower right side of the page.  That will download details of your portfolio in a notes.csv file, which you will upload to Nickel Steamroller.

Then, go to http://www.nickelsteamroller.com/portfolio

On that page, you can set a few filters if you want to analyze specific areas of your portfolio or just leave it wide open and upload your notes.csv with the Choose File button and then click on Analyze My Portfolio.

The first thing I noticed, unfortunately were some problems with the results.  My estimated ROI is shown to be 436.61%.  I may be good, but I’m not that good!

The next section down displays a Google Map with pins marked all over the US representing where borrowers that I loaned money to live.  This is really more cute that useful in my opinion.

Let’s move on and see what recommendations Nickel Steamroller made on the notes in my portfolio.  Here is where we start to see some interesting stuff.  In the screenshot below, I’ve sorted the list by the recommendation column.  You can see that in various scenarios, NSR has identified areas for improvement, and made recommendations that include:

• Sell excess note – displayed when a portfolio has more than one note per loan
• Below average interest rate – not sure the threshold, but it is certainly highlighting the lower performing notes in my portfolio
• Sell at par – whenever NSR sees a note In Grace Period, it is telling me to sell it at par (face) value.  Not sure I agree that action is needed, but they are probably worth glancing over.

Click for larger image

Overall, Nickel Steamroller provides helpful recommendations on ways to improve upon a portfolio of Lending Club notes.  It certainly found a number of weak spots in my investments that need to be improved on.  I plan to run my use this tool periodically for recommendations in the future.

But, when it comes to performance metrics, LendStats seems to provide more accurate information.  In fairness, I was even getting weird results with my notes.csv file over at LendStats when I first used it and the site owner, Ken, worked with me and found out what the problem was and fixed it.  I’d be more than happy to shares my notes.csv file with Michael at NSR to help debug the problems I’m seeing there.