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.

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