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A young trader-turned-investor whose goal is to build a portfolio which generates enough passive income to sustain his early retirement.
  • Lending Club: The Lucrative, Yet Misunderstood Income Investment

    I recently introduced my Incomers portfolio, part of which is currently invested in Lending Club (NYSE:LC) notes. I hope to accomplish several things with this article:

    • Provide a comprehensive introduction to Lending Club
    • Share my experiences as an actual investor
    • Address the risks and rewards of investing with Lending Club
    • Provide an argument for why investing with Lending Club is not as risky as many skeptics may think

    What is Peer-to-Peer Lending?

    In a market where interest rates are at historic lows for investors, banks charge too much interest and fees for loans, and credit card companies hit borrowers with interest of up to 20%, it was only a matter of time before this generation took consumer credit into its own hands. The result is peer-to-peer lending. Peer-to-peer lending is similar to other P2P concepts like crowdfunding and P2P file sharing. It takes away the middleman - in this case, the institutional banks - and directly matches individuals who are willing to loan money with those who need to borrow money. The incentive is a higher return for investors compared to what they're getting elsewhere, and lower borrowing rates and fees for borrowers compared to what banks are offering them. This is the concept behind Lending Club.

    What is Lending Club?

    Lending Club ("LC") is not a bank, it does not have a stake in the loans that it services. Lending Club is essentially a matchmaker and loan facilitator.

    Here's how it works:

    • Borrowers request for loans on LC, and for each borrower, LC will create 3 or 5 year Notes for each borrower at a certain interest rate derived from the borrower's credit background.
    • Investors will then go on to the website and choose to fund (invest in) these notes with as little as $25 per note.
    • Once all the investors have fully funded a note and the borrower's background information is approved by LC, the borrower receives the money and investors begin accruing interest on their $25. (or whatever amount they invested)
    • Investors will receive monthly interest and principal payments from the borrower based on an amortized schedule. This schedule is the same as you would get with a mortgage loan.
    • LC charges 1% of each of these monthly repayments to investors, and a loan origination fee to the borrowers based.
    • Borrowers who default are punished the same way they are with any other uncollateralized loan bankruptcy: it hits their credit score and report.
    • Borrowers can choose to pay back the entire loan at anytime.

    Why Borrowers and Investors Use Lending Club

    Many individuals are being charged 20% interest on their credit card balance, or their banks are not giving them competitive rates for personal loans. Fixed income investors are stuck with bonds at historically low yields. Lending Club creates a market where these two demographics meet in the middle. For example, borrowers with good credit can refinance their credit card loan from 20% interest to a 7%, 3 year LC loan. Investors can invest in 3 year notes at 7% vs. 0.60% 3 year treasury notes.

    Many borrowers also come to LC to consolidate multiple debt repayments into one monthly payment at a lower rate.

    Another reason to invest in LC is the lack of exposure to the stock market. No matter what the market does, LC will still go on like clockwork. There is also no headline risk; notes will not be affected by news or economic numbers.

    Starting to Invest

    Upon creating an account and funding the account, an investor can start investing in notes. Invest as little as $25 in any one note, increasing in $25 increments. Each note will have a summarized prospectus listing information about the loan and borrower. Notable info one will see are loan amount, interest rate, monthly repayment amount, FICO credit score, monthly salary, home ownership status, employment length, debt-to-income ratio, revolving credit balance, number of past delinquencies, and public files on record. Other than a few fields I haven't noted, that's all the information an investor gets before deciding to invest in a note.

    Taking the Plunge

    At first, I didn't think this amount of information was enough for me. "I'm loaning my money to a stranger who merely looks good on paper!" But I'm a "don't knock it until you've tried it" kind of guy, so I took a chance and invested some money anyway. I started investing only a little, but contributed significantly more over time. After a year as an investor and 600+ notes later, I've realized that the information Lending Club provides about the borrowers is more than we really need.

    In fact, other than the notes' grades, rate of return, and the credit scores, investors don't really need the rest of the information - only LC does. They are the ones who analyze this information to filter out 90% of loan applicants. So for us investors who buy these loans that already passed LC's rigorous screening to even be allowed to get a loan on LC, it is all just a matter of risk management and statistics. LC knows this, and investors must understand this as well.

    Diversification is Key

    As with any investment, diversification is the key to investing successfully with Lending Club notes. My suggestion to investors is to never invest more than $25 in a single note. There is no reason to take on the added risk. One can invest $50 in one note at 7%, or invest in two 7% notes and receive the same return while greatly spreading out the risk. If one person defaults, the investor only loses a maximum of $25 (assuming they default immediately) instead of $50.

    If investors follow this $25 rule, then they can start with 400 notes with a $10,000 investment. That's 400 different borrowers. If one note defaults, there are 399 other notes generating an average of, say, 8% annually, compounded monthly.

    This diversification is why I will go as far as to say that there is no significant difference between randomly choosing 400 notes vs. picking and choosing based on filters or loan criteria. The only criteria that really matters for investors is their risk tolerance, which determines the note grades and interest rates they are willing to take on. This is why LC's automatic portfolio builder only requires the investor's desired rate of return to build a portfolio of notes.

    The Statistics

    LC has pages dedicated to statistics on their website. Here is one on the account performance as of 12/16/13.

    (click to enlarge)

    Take a look at the left chart in the red box. It may be hard to see, but there is a sliver of blue in the <0% returns column. It is clear there is significantly less statistical risk for a negative return when one diversifies and invests in more notes. From their Diversification page: "As of May 24, 2013, over 99% of investors with 100 or more Notes and with no single Note accounting for more than 2.5% of their total investment, have positive returns."

    I personally do not randomly pick notes. In my mind, choosing my notes based on a certain criteria, which I've listed in my Incomers Portfolio Introduction article, will result in less defaults. It may work, or I may just be imagining it and following this criteria is merely for my comfort. At the end of the day, all that matters are my results.


    This all sounds great, but we cannot forget about the risks of Lending Club. I've thought about all of this before investing, so for the skeptics of LC, I empathize with you. But I will explain later why I converted from being a skeptic to a believer in LC.

    1. Notes WILL default, and there is a chance an investor unluckily invests in more notes that default than other investors did. The defense to mitigate this risk is to build a very diversified portfolio.
    2. Recession risk: The idea that if we go into a recession, more people may lose jobs and default on their loans. This is a risk, but it is a risk every investor takes on whether it's in stocks or LC. However, this risk is not a direct risk like it is with stocks. The notes will not default because the jobs report indicated rising unemployment.
    3. Lack of liquidity: LC notes are not easily liquidated prior to maturity. There is a "market" where investors may sell and buy notes that are already outstanding, but it is hard to sell notes for a profit or even at value if one wants to simply liquidate for cash. I have tried to sell late loans at huge discounts but still could not sell them. This is one reason most of my Lending Club investments are in my Roth IRA. I won't be needing the money anytime soon anyway.
    4. Earnings from LC notes are taxed as ordinary income. This is more of a Con than a risk, but it is important to know. This will effectively lower the returns if your tax bracket is high. This is the second reason I invest mostly in a Roth IRA.
    5. Investors are assuming Lending Club's initial screening process that supposedly rejects around 90% of loan applicants actually works. This is a very important point that will affect returns. If Lending Club begins loosening their criteria for accepting loans, then more risky borrowers will be allowed in the pool and therefore more defaults will occur. I don't believe Lending Club discloses many specifics on this.

      This fact may deter many investors from joining, as they may not feel like they have much transparency or control over what they're investing in. But I believe this should be LC's proprietary information. Much like how we accept our credit scores for what they are, but don't exactly know how they are calculated. Or how we assume that the leaders of a company we invest in know what they're doing. For some things, we just have to have faith in the management.

    6. These touted high returns will most likely lower over time. Lending Club is fairly new and all of its statistics are based only on the data it has obtained since its inception in 2006. For me, I had about an 11% return in the past year. This return will most likely drop off to a more realistic annual return of 6-8% over the long run. Lending Club is honest about this on the statistics page:

      (click to enlarge)This is a screenshot of LC

    7. Many see this awesome performance data and question whether Lending Club is being honest and accurate. Could they just be fabricating or massaging their data to look amazing? 90%+ of accounts with positive returns sounds way too good to be true. We are pretty much relying on the fact that the notes' information are accurate, Lending Club calculated everything correctly, LC is not straight up lying, and that the statistics are actually correct. This was my main concern before taking the plunge.

    Addressing the Doubts

    My first action was to do some internet searching, which I encourage everyone to do. But even as of December 2013, it is quite difficult to find complaints from LC clients, other than from frustrated people who keep getting their loan applications rejected.

    I did find one critical review of LC, which pointed out that LC was overstating returns because of pricing defaulted loans at full value (this issue has been addressed). For the article, the reviewer tried out LC and although he did not invest in 100 notes, he still came out with a positive return. It just wasn't as high a return as he expected.

    I have even heard some skeptics venture to question if Lending Club has just created an elaborate scam that is fooling everyone, even with high profile board members including Larry Summers, John J. Mack, and Google. Well, this wouldn't be the first time someone fooled everyone - remember Enron? However, if someone were to go this far, he should also question every company he invests in on the stock market. Wall Street is definitely not the poster child for morality. It all boils down to whether you believe in the management, their mission, and the system.

    Why Lending Club and P2P lending is the Real Deal

    Lending Club is a Peer-to-peer platform. At their core, P2P platforms are meant to benefit the masses, and to disrupt markets that large institutions control - to "stick it to the Man", if you will. They are meant to create a more efficient system. In this case, the Man is your neighborhood institutional bank or loan shark. Before P2P lending, if one wanted a loan, there were very few alternatives to these institutions that prey on the desperate.

    Because LC has no stake in the loans they service, they gain nothing from charging borrowers higher interest rates. But LC's image and future will only continue to shine if they maintain a system that continues to generate investors amazing returns. That is why I believe they will continue to do their best to screen out risky borrowers and maintain high quality loans.

    LC only charges a 1% fee on investors' monthly earnings. That's it, no hidden fees or penalties. They could easily charge investors a higher percentage or similar commissions to a brokerage firm, but they don't. They could also charge borrowers with ridiculous fees and penalties like banks do, but they don't. It is worthwhile to note that Lending Club is looking to IPO in the near future. So they must adhere to the same SEC regulations as any other public company.

    For all the reasons listed above, I believe the leaders at Lending Club are ethical, and will continue to run a high caliber P2P lending market.

    As for the claim that 99% of investor accounts with over 100 notes generate positive returns - does it sound too good to be true? Yes. But do I believe it's a false statement? Not really. If it is not over 99%, it's probably somewhere around the 90% range. I can't prove it, but I can't disprove it either.

    I challenge everyone to find someone, anyone, who has had a negative annual return in an account of over 100 notes and no single note accounts for > 2.5% of the account. Please provide links or screenshots for proof. Here's my proof in favor of LC's claim:

    (click to enlarge)

    I don't believe that this winning streak will continue forever, though. But I also don't believe that it will one day blow up in our faces like the stock market does on occasion. All 600+ borrowers that I have invested in must default on my loans - and ruin their credit scores while they're at it - in order to completely wipe out my account.


    Lending Club is new and innovative - these are their greatest qualities, as well as their biggest barrier. People may like innovative ideas, but not always when it comes to their money - especially if they keep going around touting such unrealistic investment performances!

    I can understand why investors may not feel comfortable investing in LC notes because of the lack of fundamental analyses required compared to stocks. Relying on statistics rather than qualitative or quantitative analysis of the business, financial statements, and economics may give a sense of less control or understanding over one's investments. On the flip side, LC provides a great substitute for currently low yielding Treasuries, and the lack of market exposure and headline risk is also enticing. It will be interesting to see what happens when rates begin to rise back to normalcy. I assume LC rates will rise as well.

    I am "bullish" in the long term outlook for Lending Club. They are in the works of expanding to other consumer credit markets, such as student loans, credit cards, and mortgages. It is an exciting time for P2P lending, and for those who choose not to invest, I urge them to at least follow its evolution and growth. P2P lending may become a vital part of our economy one day.

    With any investment, do your research and don't forget to question everything, good and bad. If you cannot find answers about something, I am sure it is ok to give LC a call. They are very reachable, from my experience.

    Feedback, comments and questions are always welcome.

    Jan 06 7:53 PM | Link | 1 Comment
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