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.