P2P Lending – A Rules Based Investment Strategy

Last week I published something of a teaser post about a new LendingClub experiment I’m playing around with. That experiment involves buying discounted loans on the secondary market.

I’m still in the process of building up my “distressed” LendingClub portfolio, and will be publishing a post about that soon, so stay tuned.

This post is not about that.

Before I publish anything about the new experiment, I felt I should first explain my “traditional” P2P lending strategy, which is something of an experiment in its own right that has been running for over a year.

P2P Lending in the Investing Blogosphere

I read a lot of different investing and personal finance blogs, and although it isn’t a super popular topic, P2P lending comes up often enough. It doesn’t seem very popular among the bloggers and comments I’ve come across.

Most of the sour opinions center around disappointing total returns, which are duly blamed on higher than expected default rates.

I for one haven’t been nearly as disappointed as most of my peers on the innerwebs. I suspect that’s mostly attributable to lower expectations, but part of me wonders if it isn’t also at least partially related to my strategy of how I invest in loans.

Is it possible that I’ve found the secret sauce to picking P2P loans?

Meh. That’s doubtful. My total annualized returns are just under 7%. The “adjusted” net annualized return projected by the robots is around 6%.

I’m not exactly setting the P2P investing world on fire.

But I think many of the elements of my strategy help temper unrealistic expectations and improve my overall psychological well being as a P2P investor. In other words maybe it helps lower default rates and maybe it doesn’t, but it definitely makes me feel like I have more control over my investment.

Per usual, none of this is investment advice. This is just what I do and why.

Read the disclaimer again if you must.

The CatfishWizard Rules for P2P Lending

Rule #1 – Don’t invest more than you can afford to lose, and don’t invest money you’ll need anytime soon.

This is a good first rule for any speculative investment, and I consider P2P investing highly speculative. We put $3,000 towards it a little over a year ago and that’s it. Last week I put another $1,000 towards the even more speculative discount loan investing strategy.

Obviously I don’t want to lose this money, but it won’t derail our retirement plans if the LendingClub account gets completely wiped out. This only represents about 1% of our liquid investable assets.

Rule #2 – One platform is enough

There are several P2P lending platforms. We chose LendingClub.

Diversification can be beneficial, but I believe that “diversification” is better focused on having a big enough loan portfolio (100+ loans) rather than spreading smaller investments across multiple platforms. Whatever the loan grade standards, collection practices, etc. by keeping everything in one place, these variables are all consistent.

Rule #3 – Ignore the Robots

I’m not sure about the other P2P lending platforms, but LendingClub goes to great efforts to try to project an “adjusted” net annualized return. The adjustment involves writing off portions of the principal outstanding for loans that are anything but current. The projection bounces around constantly as loans move in and out of various stages of lateness and get charged off or paid off early.

It’s very confusing and as far as I’m concerned a totally imaginary number. P2P lending hasn’t been around long enough to expect the models to be particularly robust or accurate.

That’s kind of the whole point, right? They’re turning the traditional lending/credit industry on its head. How much faith should we put in the robot’s projections?

I’ve noticed a lot of the folks who do blog about their P2P lending experience are constantly talking about the “adjusted” return as if that was their “yield.” It’s not your actual return it’s just a robot’s guess and it should be treated accordingly. Of course you’re going to get frustrated if it’s constantly changing and inaccurate.

I’m not really interested in the algorithm’s projections. I’m interested in the actual results, and the only way to find out what those are is to wait and see.

Rule #4 – No Automatic Investing

Again, I don’t know about other P2P platforms, but LendingClub really tries to push the automatic investing feature. “Set it and forget it!” Which is a very appealing thought I’ll admit.

Here’s the problem: they have no motivation or accountability to follow quality underwriting practices.

LendingClub makes money on volume by way of collecting fees from the payments, and loses nothing when a loan defaults. That is a recipe for a bunch of a garbage loans.

Granted, they’re being regulated and will have a tough time committing out and out fraud, but loan quality is a serious enough of a concern (and has a HUGE effect on returns) that I just can’t feel comfortable buying these things sight unseen.

I’ve set up some basic criteria to filter out loans that give me the heebie jeebies (see rule #5). While the automated investing feature would allow me to select for most of those filter criteria, there are several that can only be applied by opening up the loan listing and reading it.

Plus, setting up automatic investing forces you to reinvest the interest you receive, which is something I don’t want to do. For one that would count as putting in MORE than the original $3,000 investment and it instantly clouds the total returns picture because that reinvested interested is now tied up as “new” principal for 3 to 5 years.

Rule #5 – Don’t buy loans that don’t meet the selection criteria

There are only 6 criteria but they filter out A LOT of loans. Here are they are, listed as sub-rules for the purposes of this post:

Rule #5.1 – Only buy loans with zero delinquencies in the last 2 years

I’m sure there are people who have had recent delinquencies and are actually very well-meaning and responsible. I just don’t want to loan money to them. Sorry.

Rule #5.2 – Only buy loans with a C, D or E grade (~13-22% interest rate)

Most of the loan history data available are related to charge off rates, so this is pure speculation, but I suspect that A & B rated loans would be more likely to be paid off early, which also negatively impacts total returns. The logic goes: A & B rated loans represent more financially savvy, responsible borrowers, who should be expected to do more financially savvy and responsible things…like pay off debt early.

F & G rated loans are obviously at a higher risk of being charged off, which is the biggest source of reduced total returns. I’m leery whether or not the increased charge off rates are adequately offset by the higher interest rates.

So we stick to the middle of the road.

Rule #5.3 – Only buy loans where the borrower’s income has been verified.

Honestly I can’t believe this isn’t the default. When you select this filter, a warning message pops up letting you know that most loans get funded before the borrower’s income gets verified and that this is limiting your selection of loans.

Seriously?

Rule #5.4 – Only buy loans that are for “Debt Consolidation” or “Credit Card Refinancing”

Want to do some home improvement? What’s the reason you couldn’t get a HELOC? Why do you need me?

Vacation or wedding? Those are horrible reasons to go into debt.

“Major Purchase”? What are you buying? Why do you need it now before you can technically afford it?

“Business loan”? Sorry I want to see your business plan first. Also if I don’t have any seniority, maybe I’d rather have an equity stake?

I used to consider “Medical Expenses” since that’s the only other thing I could think of that might justify getting a loan with this kind of interest rate. The problem was that messed up rule #5.5 below, and there’s no detail on what exactly the medical expenses are anyway. Plastic surgery? Pass.

Rule #5.5 – Only buy loans with a total loan amount less than or equal to the revolving credit balance.

If you have a $17,000 revolving credit balance and you’re making $3,200/month you have a problem. You really should pay off that credit card debt, and a 15% interest rate is probably better than what the credit card company is charging you.

I am willing to help.

But if you ask for a $25,000 loan, I have to assume that you’re up to something incredibly irresponsible with the other $8,000.

Sorry. No deal.

Now I’m not clear on the difference between “Credit Card Refinancing” and “Debt Consolidation”. Presumably the latter could also include things like payday loans or student debt in addition to credit cards.

I think people sometimes might check either one when they really are just trying to deal with credit card debt. But a “Debt Consolidation” loan could be trying to pay off “other” debt that doesn’t show up as “revolving”.

I’d be surprised if your student debt is over 13%, and I’m not sure how interested I am in messing with people who have taken out payday loans. So this rule theoretically limits my loans to people who are trying to pay off credit cards, which is something I strongly support.

Rule #5.6 – Only buy loans where the borrower has a job title other than “n/a”, and that job title is spelled correctly.

Even if your income is verified, it’s hard for me to understand how you earn it with “n/a” as your job title. Is that a prejudice against entrepreneurs? IDK maybe. If you own your own business you should put “owner”…

Is that prejudice against people who aren’t very literate or maybe just made a mistake? Yup. You’re asking to borrow money. Get your shit together. You’re not a “technishun”.

The last two criteria are the ones that I haven’t been able to automate, and frankly I don’t think I want to. Making an unsecured loan to a stranger on the internet is pretty risky. I feel like I should be reading the loan listings and this forces me to do that.

Plus even if all this doesn’t really drastically lower my default rates, at least I’m helping people with marginal credit get out from under high interest debt. Overall that’s a win for society. 

So those are my rules for P2P lending.

My next P2P post will be about buying discounted loans on the secondary market, which is different, but I think it will make more sense now that I’ve shared these rules for choosing new loans.

What do you think about my strategy?

Am I crazy for reading the loan listing before investing?

Are robots infallible?

I look forward to your comments!

2 thoughts on “P2P Lending – A Rules Based Investment Strategy

    1. Not investing advice!
      But I get your meaning. 🙂

      The convenience of the auto-invest feature comes at too dear of a price for me.

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