In late 2012 I made my contribution to my Solo 401(k).
As a business owner there is nothing sweeter than getting a nice big fat tax deduction.
After I deposited it into my account it sat there in cash for a considerable amount of time.
It sat there WAY too long….
The funny thing about being a financial advisor is that I spend 99.9% of the time managing my client’s money and about .01% of the time managing my own money.
Oh the irony….
As I sat there watching my cash grow at a snail’s pace the market continued to soar, and soar, and soar and soar.
Basically to the point where I felt that it hit a high. In hindsight it turns out 14,000 wasn’t even close.
To avoid buying at the high I thought, “You know what, I’m going to give peer to peer lending a real shot.”
Testing the P2P Waters
At the time I never had heard of peer to peer lending but there was a lot of chatter in the bloggersphere about it so I was wanting to test it out. I thought what the heck, “let me deposit $2,000 and see what happens.”
I went conservative with that account and to this day I’ve averaged between 8.5% to 8.9% interest -not too shabby. Obviously the market has returned a lot more but still not bad for a stable interest paying account.
Knowing that many people that invest in peer to peer lending end up going more aggressive I thought if I’m going to do it I’m going to do it right. Once again wanting to diversify I thought it would be wise if I split up my accounts between Lending club and Prosper.
Currently these are two of the largest peer to peer lending companies that are in the market and I thought it would be cool to put them side by side. Somehow my math wasn’t even close and I ended up putting more with Prosper. The logic at the time was that I already had some money in Lending Club so I would try more with Prosper.
The other logic behind is that I had talked to other people that were pretty heavily invested into Prosper and they had claimed that they were able to get higher returns. I’m not sure why this is but I was all about it.
As we’re approaching the one year mark I thought it would be cool to go back and see how each account has done compared to the other. I also want to get more insight into how these two peer to peer lending giants work so you can understand the process.
Quick Primer on Peer-to-Peer Lending
As with any lending situation there are two groups: borrowers and lenders.
Instead of going to a bank or a credit union to get a personal loan in order to pay off debt, the borrower requests a loan from the P2P lending website. The P2P company — Lending Club or Prosper – vets their application, checks their credit, verifies employment and income numbers, and approves or denies the loan.
The borrower’s rate is set based on their credit, so someone with “B3″ credit (relatively good credit) might have an interest rate of 11.99% and a 36-month APR of 14.85%. That might sound like a lot, but if you’re holding $10,000 of credit card debt at 22% this sounds like a phenomenal rate.
Borrowers not only drop their interest rate. They get a fixed payment, a fixed term, and the knowledge that if they make all of those payments they will completely pay off the loan. Compare this to dealing with minimum payments, late fees, and random charges on credit cards.
P2P can really work in saving users tons of money on interest — and some borrowers have even been able to get new loans at even lower rates after making consistent payments on their original P2P loan. Kind of like refinancing the loan down to a lower rate to save even more money and get out of debt that much faster.
P2P Lenders or Investors:
When it comes to P2P there is no bank approving the loan and lending out the money. Instead there are tens or hundreds of individual investors that read through the loan description and decide whether or not to fund part of the loan. Typically the lowest investment in a loan is $25, but investors can choose to invest more than that if they want.
Investors look for things like interest rate, total debt-to-income, how long the person has been employed at their current job, if they have any credit delinquencies, and what the person is going to use the loan for. (Hint: it helps to have a really good explanation of what you will do with the funds!)
If enough investors come together to meet the total loan amount, the loan is funded and the money is sent to the borrower. As the borrower makes payments the P2P company processes them, takes a small processing fee, and passes the remaining principal and interest to the investor.
It’s a win-win. People in debt get out of debt faster. Investors looking for higher returns can get them. Everyone is happy.
Who is Lending Club and Prosper?
Here are some interest stats:
- Lending Club, total loan amounts funded to date: $3,166,340,675
- Lending Club, total interest paid to investors to date: $288,107,104
- Prosper, total loan amounts funded to date: $692,000,000
Prosper came first, and Lending Club came next to kind of blow the market wide open. Each site has its strength and weaknesses. I personally prefer Lending Club’s site because it seems a little more modern, but as long as everyone is making money we should all be happy.
Show Me The Money
As I mentioned above, my plan was to have these accounts opened by the beginning of the year so I could start investing and track side by side. A few things held that up….
When I opened these accounts I had just opened a self-directed Solo 401k that had special trust documents that went along with it. Since it wasn’t your basic investing account, both Prosper and Lending Club had to go through the documentation with more scrutiny that delayed getting the accounts opened.
Prosper was the first one to verify the Solo 401k trust and get the account opened. Lending Club, however, took much longer and didn’t approve the account until April 7th.
I’m not really sure the difference of the approval process, but that should be taken into consideration.
One final observation is that Prosper seems to have a greater supply of notes where I was able to get my full $25,000 invested much faster than it took Lending Club to get my $15,000 invested.
Okay, now for the numbers…
- Starting Value: $25,000
- Ending Value: $28,302.92
- Growth: $3,302.92 or 13.2%
- Annualized Return: 16.72%
- Starting Value: $15,000
- Ending Value: $15,895.54 ($777 of that in cash — d’oh!)
- Growth: $895.54 or 5.97%
- Annualized Return: 18.04%
As you can see the actual growth versus the annualized return for each is off.
How Do They Calculate Your Return?
There is a big difference between seeing your account value grow and the “annualized growth” return shown by both Prosper and Lending Club.
How each company defines annualized return (or net annualized returns) is below, but let me try to summarize.
Annualized return is where the company takes your current returns and annualizes them for you. If you’ve been investing in loans for 6 months and enjoyed high returns during that time, the annualized return divides your simple returns by 6 months and then turns them into an annual figure.
This can throw things off quite a bit due to the following issues:
- You earn more interest on the front end of a loan than the back end. Toward the end of the loan you are getting mostly principal back and very little interest. (This is why constantly reinvesting is so important and why I’m kicking myself for having over $700 sitting in cash in Lending Club.)
- Charge offs or defaults likely haven’t hit your account yet. The calculations are assuming that all of your loans are going to be completely repaid. Odds are that isn’t true.
I’ll tell you more about defaults in a minute, but let’s see how Prosper and Lending Club define annualized returns.
To calculate Annualized Returns, a total gain or loss is calculated by summing all payments received net of principal repayment, credit losses, and servicing costs. The gain or loss is then divided by the average daily amount of principal outstanding to get a simple rate of return. This rate is annualized by dividing by the dollar weighted average Note age of your portfolio in days and multiplying by 365.
Net Annualized Return (NAR) is a cumulative, annualized measure of the return on all of the money invested over the life of an investment. NAR is based on actual borrower payments received each month, net of service fees and actual charge offs. NAR is not a forward looking projection of performance and it reflects the full principal amount of a Note until the corresponding loan charges off, even if the borrower is late on their payments.
When you start investing, your NAR approximates the interest rate of the Notes you have invested in, less any service fees. Over time NAR will start to decrease slightly if payments are missed from delinquent borrowers. Should a loan charge off, the invested principal will be written off and the impact to NAR will be more material.
How Much Do Defaults Affect Your Return?
If I gave you $25 and you gave me $5 back and disappeared, I’d be short $20.
If you lend money to someone and they don’t pay you back, does that impact your returns?
Uhm… YEA it does. Ouch.
Diversification is absolutely key in maintaining quality returns. Lending Club’s stats show that if a loan portfolio has more than 100 loans in it that 99.9% of those portfolios have a higher than 0% return. About 10% of those portfolios have a 0% to 6% rate of return, the remaining 89.9% earn a rate of return higher than 6%.
In an effort to be transparent, Lending Club provides some excellent statistics including this chart to the right.
As you can see the best credit (A) gets the lowest average interest rate. The average rates increase as the credit rating gets worse.
But we don’t care about average interest rate. That doesn’t show loan processing fees or charge offs (defaulted loans). That’s where Adjusted Net Annualized Return kicks in.
Look at some of the differences:
- “A” credit loans only drop a little bit, and that’s to be expected because those borrowers have and want to keep excellent credit.
- “D” loans statistically outperform “C” loans despite having a higher average interest rate.
- “E” loans statistically outperform all other loans, even “F” and “G” which have higher interest rates. This tells you that those “F” and “G” loans have the most defaults, and those defaults are a drag on returns.
In short, yes defaults impact returns. Diversifying to lower your risk is key to being successful with P2P investing. Don’t put all of your money into just a few loans.
How Do You Sell Your Notes?
What if you want to get out of P2P lending or you want to change your loan strategy to a different risk level? You can sell your loans on a marketplace without having to wait for them to be paid off. (This is a good thing since loans run 36 or 60 months. That’s a lot of waiting.)
To sell your loans you must first register as a “trader” with a registered broker dealer that runs the loan marketplace. That marketplace is run by a company called Folio Investing, and it charges a 1% fee of the selling value of the loan to operate the marketplace.
From there you simply select which notes you want to sell and what you want to price each loan at individually. Investors looking to buy up these loans can sort them by interest rate, principal left, markup (or discount), and yield to maturity.
The last two are the most critical: loans can be sold at 0% markup (or at value) in order to sell faster, but that means you’re losing out on the 1% transaction fee. If you price it higher than 1% above the loan value you can actually profit from flipping loans. Likewise if you’ve got a loan in the midst of going bad you can try to discount it a bit to let someone else deal with seeing if the borrower gets back on track.
Closing Thoughts on Lending Club vs. Prosper
Overall, I’ve been more than satisfied with both Lending Club and Prosper.
I feel that Prosper allows me to reinvest much more automatically than Lending Club although Lending Club is now offering their “Prime” service that I think helps with this but at a cost.
As part of the Grow Your Dough Throwdown I’ll be investing $1,000 into each of these and tracking the results over a year’s time.
Between that and updating this post with returns as the Prosper vs. Lending Club Experiment continues should give you a good idea which company you might want to try.
Have you invested with Lending Club or Prosper? How did it work for you?