Countering The Arguments Against P2P Lending

MMD: Today we have a mega guest post from fellow personal finance blogger ARB.  Take it away!

Hello, readers of My Money Design! I am ARB, the Angry Retail Banker!

Over on my blog, I offer what I call “An Insider’s Take On Retail Banking”, which means that between bouts of raging out and threatening my entire customer base with physical harm, I talk about both life as a branch banker and ways for you to maximize your banking relationship.

I am here today to talk about absolutely none of that stuff.

Before you all hit the back button on your browser and type “funny cat videos” into a Google search, know that I’d like to discuss an awesome form of passive income that I think doesn’t get covered a whole lot.

I’m talking about Peer-to-Peer (or P2P) lending and I will be addressing some of the common arguments against it.

 

What Is P2P Lending?

I actually first heard of P2P lending right here on My Money Design and have been smitten with the concept ever since.

While I’m sure the veterans of the passive income community already know what P2P lending is, let me take a moment to explain the basics to the uninitiated.

P2P lending is a form of loaning money that bypasses the banks and other financial institutions almost entirely.

Instead, borrowers looking for loans are matched with individual investors looking to lend out their own money with interest. Essentially, individuals act as banks and make a profit in the same way that the banks typically do.

The two major P2P platforms in the United States are Prosper and Lending Club, the latter of which saw Google as a major investor before becoming a publicly traded company.

Both borrowers and investors (or lenders, I should say) would sign up for an account with either or both platforms.

Borrowers would then submit their loan applications while lenders would transfer funds to their accounts. Once the borrower is approved for the loan, it becomes visible on the site to the lenders.

Lenders go through the list of available loans and decide which loans they want to fund and how much of each loan they want to fund (as little as $25 per loan).

Once a loan is fully funded and distributed, the borrower repays the loan via monthly payments that cover both principal and interest. Those payments are distributed to the investors who funded the loan.

Pretty much it’s regular people lending money to other regular people. You can imagine it as yourself taking on the role of the bank, or as being a bond investor where the bonds represent real people rather than governments, municipalities, or businesses.

Either way, expect that at least one out of every three people you try to explain P2P lending to will look at you and un-ironically ask you if you are a loan shark.

Why Should I Be Interested In P2P Lending?

Is my word not good enough for you?

Alright, how about the fact that most experts believe you can earn a 5-12% return on your investment in P2P lending. Now understand that this is not a hard number or a guarantee; your results will depend on the loans you choose, your loan filters, your risk tolerance (you want the riskiest loans or the safest?), and the state of the general economy.

I’m not telling you what you will or won’t make. But it seems to be the average for many institutional investors and industry experts and it seems to be the average whenever I do loan back-testing (more on back-testing later).

Now, there will be a downward trend in the ROI (Return On Investment) of every portfolio. A new portfolio hasn’t had a chance to experience defaults yet. But even taking this into account, looking at all of Lending Club’s loans issued since 2009, we still see a ROI of 8.68%.

Not bad, huh?

Compare that to your savings account getting you 0.01%.

And P2P lending is gaining grounds amongst some personal finance bloggers who are letting the results speak for themselves. Mr. Money Mustache, for example, has seen returns so far of about 12.22% as of this writing. I credit the mustache for his success.

But Mr. Money Mustache isn’t the only wildly popular, immensely successful, and amazingly good looking blogger to enter the P2P sphere. I’m, of course, talking about me. I said “amazingly good looking”, right?

For those of you who must know how much I’m making, I started with Prosper a little over a year ago and Lending Club a few months after that. My Prosper account has returned me about 9.93% for all the notes that are over ten months old (thus properly weeding out the defaults from the ROI), while my younger Lending Club account (invested entirely in low grade, high yield loans) as a return of 12.84% after taking defaults into account.

Of my 164 Prosper loans, only 7 are late and 2 have been charged off (with 13 being paid in full already). On the Lending Club side of things, I’ve got 237 loans with 4 of them being late, 1 still in the grace period, and 1 charged off (14 of them have been fully paid). While I expect the default rate to increase as time goes on, that’s definitely not the risky “Vegas gambling” many people see P2P lending as.

Now the worst, most dishonest thing I can do is sit here and tell you that you will make a ton of money because I’m doing good so far, but I just want you all to get a feel for what the general returns have been since 2009. I truly doubt a mature portfolio will see consistent 15% annual returns, but I do believe that P2P lending can offer you better returns than even my beloved dividend stocks, though with much greater risk (so I do recommend keeping only a small portion of your greater investment portfolio in P2P loans). I have companies that pay 3% in dividends; I have loans with interest rates over 20%.

 

Taxes On P2P Lending:

For those of you who forgot, MMD wrote a nice little eBook recently called Save Better (which everyone should go and buy already) in which he taught you all the ways you can save money on your taxes. One of the ways to gain a tax advantage was by investing in stocks for the long term. Dividend and capital gains taxes are lower than the ordinary income tax rate that your paycheck is taxed at.

But what about your P2P lending returns? How are they taxed?

Unfortunately, your returns are taxed as normal income, and if you’ve ever found yourself complaining about how much the government takes out of each paycheck (like I do every two weeks), then you are going to find this to be a major downside to this form of investment.

Fortunately, both Prosper and Lending Club allow you to open up an IRA with them, greatly minimizing your tax burden. And like stocks, charged off loans in your taxable account can be written off as losses, according to this post on Lend Academy, a popular P2P lending blog.

 

P2P Lending In Your Area:

Funny thing about P2P lending. Not all states allow it.

I’m not going to go into why certain states have still not allowed P2P lending (why does any politician support or oppose anything? Votes and money), but some states allow you to enter the P2P lending world, and other states do not.

What’s crazier is how complicated these restrictions are. It’s not simply a matter of the whole asset class being allowed or blocked. Rather some states allow you to borrow but not lend, and some states allow you to do business with one company but not the other.

A potential investor may find themselves allowed to borrow from Lending Club and Prosper but not actually lend money out themselves. Another person may find themselves limited to doing business with Lending Club but not Prosper.

As far as investing goes, 28 states allow you to invest in Lending Club while 31 allow you to invest in Prosper. The breakdown for Lending Club is as follows:

And here’s Prosper:

If you live in a state that doesn’t allow P2P lending at all, then you’re pretty much out of luck.

But what about you non-’Muricans that don’t live here in ‘Murica?  You might want to check out what P2P lending companies exist in your country.

Europe has a number of different P2P lending companies headquartered in the United Kingdom, France, Spain, and Germany, of which some of the best ones are listed in this Forbes article.

P2P lending has also broken through the Great Firewall of China. There the amount of money that has been issued in loans has increased by 300% since the same point in time in 2014.

The Asian Banker actually takes the time to list all P2P lending services by country. This asset class is not just limited to the Western world; these markets are also in Australia, Hong Kong, India, and South Korea. No word on when North Korea will be getting in on it (probably never).

 

The Arguments Against P2P Lending:

Now that I’ve educated you on a few aspects of P2P lending, I want to really get into the meat-and-potatoes of this article.

You see, every type of investment has its risks, and P2P lending is no exception.

The biggest risk of a P2P loan is that of a loan default. A person might lend money to a borrower only for that borrower to never repay the loan.

But you could say that about any type of investment. Stocks could go up and down, or the company can go bankrupt. Bonds can also default. Not all bonds are as safe as the U.S. Savings Bond. Real estate investment income can erode due to vacancies, maintenance, and deadbeat tenants.

I could literally go down a list of passive income ideas and come up with a reason to avoid every single one.

I’ve heard a lot of arguments over time about why “you shouldn’t be lending money to random strangers over the Internet”. Some arguments against P2P lending were very well crafted and thought out. Others, not so much.

I’m not going to sit here and try to convince everybody that P2P lending is the best investment or form of passive income for you. Nor am I going to analyze whether P2P is a viable threat to the banking industry or compare them to traditional bank products like I did awhile back with prepaid debit cards. That is all outside the scope of this article.

Instead, I will opportunistically and shamelessly promote my blog using someone else’s resources in order to drive … I mean … address some of the arguments that I have heard against P2P lending and offer my counterarguments.

Argument #1: “What happens to you if the borrower defaults!? These loans don’t have any collateral!”

Do you know how many times I’ve seen this excuse presented as “The Big Secret The P2P Lending Platforms Don’t Want You To Know” or something like that?  The notion that these loans are backed only by the good faith and credit of the borrowers?

This message is presented in this hushed whisper of a tone, like a crazy living-off-the-grid survivalist who is trying to tell everyone that bank tellers are calling the police on their customers without Obama overhearing and personally ordering a hit squad to cover his tracks.

It’s absolutely true what they say. These loans are backed by absolutely zero in collateral!

There is no home, car, or any other hard assets to recover in case the borrower doesn’t pay back the loan. And if the borrower defaults, you lose the money you lent that person.

But that’s just like a regular credit card or bank loan!

The fact that you don’t lose your home if you default on a bank loan doesn’t deter Bank of America from offering them, does it?

The fact that the bank can’t debit your bank account to pay unpaid credit card bills doesn’t stop Chase from getting you to apply for them, right?

And the banks seem to be making quite a bit of money off unsecured loans. They are certainly making record profits, according to this Wall Street Journal article from late 2014 which also pointed out that banks’ outstanding loans have topped $8 trillion (yes, I know much of this is mortgage lending) since research firm SNL Financial first started tracking them in 1991.

My response to someone worried about borrower defaults is to diversify. Diversify heavily!

Banks are able to withstand loan defaults of tens of thousands of dollars per borrower not just because they already have billions of dollars in assets, but because each loan is such a tiny part of their overall loan portfolio that the loss of the entire principle of one loan is completely covered by the interest payments on the rest and then some.

You should do the same! Don’t loan $15,000 to one borrower. Loan the minimum of $25 to as many different borrowers as possible.

In the end, the cost of a borrower default will be greatly minimized and your losses will be nearly non-existent.

Even the lending platforms themselves recommend this tactic. And make no mistake; it is the single most important thing you can do to protect yourself.

Prosper’s website even states that since 2009, every investor who has purchased at least 100 notes (loans) has had a positive return on their investment.

Using the website Nickel Steamroller, which allows us to see the actual results (including ROI and default rating) of past loans, we can see that even a portfolio with only the riskiest loans gives us a positive ROI.

More than “positive”, if you had started in 2009 blindly throwing your money Prosper’s riskiest loans with no regard for the purpose of the loan, the borrower’s credit score, income, number of recent credit inquiries, etc., you would have had a staggering 12.61%  return on your investment (with at least one year in there passing the 17% mark)!

More importantly (with the exception of 2010 and 2011), the rate of defaults has steadily decreased since 2009.

Now this doesn’t mean that you should go out and pour all of your money into the riskiest loans than P2P lending has to offer. I am simply showing you the numbers (actual real-world results, not just theoretical models or future predictions) that show the power of diversification, which in turn shows that the risk of borrower default is not something that should scare anyone away from this form of investing.

Even if 20% of our hypothetically lazy and careless lender’s loans had defaulted because he was targeting “the riskiest of the risky”, he still would have made $12.61 for every $100 invested as long as he simply diversified and invested only the minimum amount spread out across the maximum number of loans.

 

Argument #2: “You’re not investing! You’re just gambling! You have no way of knowing if these random people will pay you back!”

It’s true that past performance is no guarantee of future success, and that even with the numbers I quoted for you, it’s still possible for any individual loan to default.

You don’t see past the numbers on the screen. You don’t see the borrower behind it. Who knows if “bob_almighty111” is going to pay back that $25,000 loan?

Lots of things can happen. What if Bob loses his job? What if Bob is a deadbeat? Are you a deadbeat, Bob?

But two things about that.

First, Prosper and Lending Club are major companies that deal in consumer lending. Don’t you think that they have strict underwriting guidelines that they follow?

Lending Club goes over their basic requirements here, and it’s pretty much the same criteria that the banks use.

Peter Renton, a respected member of the P2P community and the owner of the popular P2P lending blog Lend Academy which I mentioned earlier in this article, detailed in 2013 some of the changes in Lending Club’s underwriting requirements.

While these changes make it easier for borrowers to get approved for loans, it does so in a way that doesn’t increase the lenders’ risk, showing the care and effort Lending Club puts in their analysis of both individual loan applications and historic trends.

Prosper had a more storied history.

Remember how I wrote before that all their lenders since 2009 made a positive ROI if they diversified? Well, Prosper was around before 2009. The Prosper of old was a wildly differently run business than the Prosper of today. We are better off for it. The old Prosper, or “Prosper 1.0” as it’s commonly called, pretty much handed out loans to anybody who asked nicely, which is what my customers seem to think my bank is obligated to do (pro-tip: Having a checking account with over $1,000 does not guarantee you a loan).

This led to default rates reaching obscene levels of roughly 35%. Eventually they got busted in 2008 for selling unregistered securities and had to be reorganized into what is now informally called “Prosper 2.0”, complete with SEC regulation and everything.

So now operating within a proper regulatory environment and maintaining an underwriting process that doesn’t involve the words “yes to all”, Prosper’s ability to filter out the bad loans from the good has been almost immediately visible.

Their investors are earning positive returns and they have an A+ rating from the Better Business Bureau.

But why take anyone else’s word for it when you could be your own underwriter?  … Sort of.

I mentioned a couple paragraphs back a site called Nickel Steamroller, right? Right.

And as I very briefly mentioned, that site lets you back test actual loan results, complete with filters. This means that you can actually apply certain sets of criteria, plug in the data, and see how well real loans that fit that description did in earning their investors a return during a certain time period.

For example, you want to know if lending to the state of California would increase your loan defaults. Or perhaps you are looking to see which loan purpose will net you the highest return.

You can apply filters such as credit score, home ownership, open credit lines, loan grade, literally anything. You can search for how loans that fit that criteria did during a time period of your choosing.

This isn’t how some analysts or a computer program think such loans might do. These are actual results of real loans and what they made for real investors.

Gambling is throwing your money on red and hoping for the best.

Gambling is putting all your money into one or two loans and hoping that you see that money again. But with the ability to back test loans—to look at loans of different criteria and see their real world results—you can effectively do your own “underwriting”, formulate your own strategy, and know what loans are more likely to be paid back and what loans are more likely to fail.

Again, you have no way of knowing if any individual loan will be paid back, and it is true that defaults are just part of the game.

But knowing that certain types of loans in certain areas for people underneath a certain credit score have historically had high rates of default allows you to lower your own default rate by avoiding those loans.

You’re not just closing your eyes and throwing your money at random people when you have real world data that tells you which groups of borrowers have paid back loans in the past and which ones have a history of taking lenders’ money and running.

 

Argument #3: “Has this asset class been stress tested? Who knows what will happen if another financial crisis strikes!?”

Oh yes, P2P has been stress tested.

This has been stress tested through more financial crises than you think. And it has survived the worst of the worst. Forget the Great Recession, this asset class has survived the Great Depression!

How is this possible, you ask? Are all bankers mighty and omnipotent time lords?

Yes, yes we are, but that has nothing to do with P2P lending. Again, I point you right back to my first counterargument as we look at the borrower’s side of the equation.

Before, we looked at one aspect of P2P loans that were similar to bank loans; the lack of collateral. Not all bank loans involve collateral such as your home and car.

Credit cards are a prime example of unsecured debt, or debt backed by nothing but a borrower’s credit history and promise to repay.

But let’s take a closer look at the actual loans offered by Prosper and Lending Club and see what else is similar.

Let’s see: P2P loans are fixed rate, unsecured loans offered with three to five year terms. The loan amounts range from a couple thousand dollars to $35,000 and are paid back in monthly installments with principal and interest being applied to every payment.

Hmm … these don’t sound similar at all to bank loans. No, instead they sound exactly the same!

Literally, the only differences between a basic personal loan from a bank and a P2P loan is that the bank directly profits in the former while individual investors directly profit in the latter, and I have to deal with angry customers wondering why they haven’t been given a closing date yet in the former while I don’t have to deal with the general public at all in the latter.

… Wait, I think I figured out why I like P2P lending so much.

So if a P2P loan is simply a standard unsecured personal loan that you would find at any bank, then surely it’s an asset class that has been around for decades and decades and has been stress tested through many different financial crises and economic downturns.

The banks are still here, still offering these loans, and still making money on them.

In my eyes, P2P lending isn’t really a new asset class at all.

It’s not some exotic new thing that even the most seasoned financial advisers have trouble understanding. They aren’t mortgage backed securities or anything like that.

They are the same simple, easy to understand fixed rate bank loans that people have been dealing with for decade upon decade upon decade upon decade. They have been stress tested to Hell and back and they have passed.

The only thing new is that you have a chance to earn money from these loans rather than Jamie Dimon (Chase’s CEO).

 

Argument #4: “The people applying for these loans must be some serious deadbeats! If they had good credit, then why wouldn’t they just go to the bank like everyone else?”

P2P lending is just starting to dip its toes into the world of mainstream finance, but it’s not there yet. It’s still a brand new asset class as far as your average investor is concerned.

Most people have never heard on it and have to have it explained to them, while everyone knows about the stock market or buying rental property. And when the average person needs a loan, the first thing they do is go to their bank. Or their parents.

I have seen many people imply P2P loans to be “the back channels of lending”, as if the borrowers were dealing with shady loan sharks in the basement of a Mafia-owned bar. They ask why would someone go out of their way to borrow money at ridiculously high interest rates (Lending Club’s highest APR is over 26%, while Prosper loans can hit the 35% mark) from a lender that no one’s ever heard of when there is a reputable bank on every street corner that they can deal with (and speak to a lending professional as well).

The thing is that many of those reputable banks have very strict underwriting criteria. While they have been loosening their requirements, those underwriting requirements became much stricter in the years immediately following the financial crisis and still have not returned to those levels.

I fully support the tightening of lending standards since banks can only afford so much risk on their primary method of making money (sorry, increasing the amount of deposits is worthless as far as increasing revenue goes since banks don’t make money that way), but that means that it is really hard for Bob the Borrower to get a loan.

But while the big banks are only dealing with borrowers that have perfect or near perfect credit, Prosper and Lending Club will deal with people that aren’t quite at that level but can demonstrate that they will be able to pay back a loan.

Someone who has been successful at making timely credit card payments at 30% interest should be able to pay back a debt consolidation loan at 15%, even if they don’t have the best credit or income. The P2P platforms have their underwriting guidelines, but they are less strict than the banks and will lend to people with subpar credit if those people demonstrate the ability to pay back their debt. They will deal with Bob when the big banks won’t.

But okay, so P2P platforms are geared towards riskier borrowers then? That sounds, well, risky.

Sure they can justify charging these people higher rates, but it sounds like an investor is playing with fire by de facto dealing with only subprime borrowers.

And if P2P lending is going to become mainstream in the investing world, it has to become mainstream in the lending world as well. It has to do that first. Which means attracting prime borrowers.

Why would someone with perfect credit go out of his way to learn about Lending Club when they probably have a Chase right around the corner?

This is where a personal banker is best suited to answer that question. The answer is the interest rates.

If you were to walk into my bank with your perfect credit score and apply for a loan, you will probably be offered a rate somewhere in the 9-10% range.

But look on the websites for the P2P companies. While they are known for exorbitantly high interest rates, those are only for their riskiest borrowers.

Borrowers with good enough credit to qualify for the highest rated loans (A-rated loans) earn the lowest interest rates, around 6.5%.

So imagine someone with perfect credit and a very high income is being offered two loans, one from Lending Club and the other from Chase.

They are both unsecured fixed rate loans with a 3 year term. The person can even apply online for each without leaving their home.

The two otherwise identical loans, however, come with different rates.

Lending Club’s is 6.5% while Chase’s is 9.5%.

Which do you think our hypothetical borrower will choose?

Exactly!

When you loan money to people, you aren’t just giving your money to deadbeats who survive off payday loans and minimum wage.

These aren’t the bottom of the barrel borrowers who were laughed out of the banks. These are prime borrowers who shunned the banks because they wanted a better deal.

Many of the borrowers are the sort of borrowers that the banks look for, that the banks make money off of.

But these borrowers have gone to P2P companies instead, where you make the money.

As a side note, we’d never laugh you out of the bank. We usually wait until you’re gone.

Final Thoughts:

……….Take care of yourself and each other?

I’m not expressly making the case for P2P lending here. Even though I am a lender, I am not arguing that it is awesome and everybody should do it.

There are pros and cons for all asset classes, P2P lending included. But these are arguments against P2P lending that I’ve heard here and there that I had to address because I honestly feel they don’t hold any water.

1. We know the loans don’t have any collateral; they are the same unsecured loans that a bank offers.
2. It’s not gambling; we can back test these loans to see how they’ve performed historically and only invest in the types that give us the most likely returns.
3. It’s been stress tested; these are basic consumer loans that have been around for ages.
4. And these aren’t deadbeats who can’t pay their debts coming for more money; many of them are prime borrowers who rejected the high interest rates of the major banks.

I’d like to thank MMD for giving me a chance to voice my opinions on P2P lending. I will now repay him by attempting to steal his readership using this picture of an adorable puppy.

Readers – Who among you has tried (or thought about trying) P2P lending?  What have your experiences been like?

 

Featured image courtesy of Pixabay.com.  See captions for all other image sources.