5 Ways to Lose Money with Peer-to-Peer Lending

About a year ago I began researching investments; trying to determine how best to put my inheritance to work so as to contribute to long-term financial security for my family. My husband and I have been investing in mutual funds regularly since we married, both through our retirement plans and independently. However, we had been on auto-pilot for years and since we now had a large sum to invest, I wanted to make sure we were doing the right thing. During the course of my research I learned about peer-to-peer lending via Lending Club and decided to invest a small amount of money to "kick the tires". I decided I liked what I found and I have since that time invested about 5% of our investable assets in Lending Club and its main competitor, Prosper. Over the last year I have learned that returns over 5% per Annam are not hard to get. I have also learned some ways to lose money, and of course, I learned some of them the hard way. So you don't have to learn the hard way, here are some ways to lose money with peer-to-peer lending:

Don't Invest Enough Money

That sounds counter-intuitive--the more I invest, the more I can lose, right? Yes, and no. Just as investing in a broad index based mutual fund means that you will not hit a home run, nor will you generally strike out, investing in just a few peer-to-peer notes means that you will either hit a home run, or strike out. Buying a lot of them means you will buy the average. Peer-to-peer notes are unsecured personal loans; like credit cards they require no collateral. Generally speaking the amounts owed are low enough that collecting via the court system is not cost-effective. A certain level of defaults is a given, and those defaults are the reason for the seemingly high interest rates. If you invest in only a handful of notes, be they large or small, you are more likely to end up with a return that is extraordinarily high or low than you are if you purchase more than one hundred notes.

Let Cash Accumulate

Used with Permission

Unlike many other investments, peer-to-peer lending returns both principal and interest to you daily. That is a good thing if you want to maintain your options or if you want to withdraw money for specific needs at specific times. Last month my Lending Club account paid me $608.70 in principal and $201.37 in interest. If I took no steps to reinvest that money, it would be sitting there earning nothing. You can set your Lending Club or Prosper account to reinvest the payouts automatically, either through their platform (at no cost) or through some third-party tools like Blue Vestment or Lending Robot (which charge fees). If you do not choose to use those tools, you need to log in regularly to reinvest your returns.

Pay Too Much Premium for Resale Notes

Both Lending Club and Prosper allow investors to sell the notes they have purchased via trading platforms. While Lending Club and Prosper set the original price and interest rates of the notes, the resale market is one of supply and demand. I can ask any price for any note I own, and you can choose to pay it, or not. The resale platform will show a potential buyer the asking price of the note, the amount of principal outstanding, the interest rate, the number of payments left on the loan and the debtor's FICO history. It also shows a yield to maturity, which takes into account the service fee by Lending Club as well as any premium being sought by the seller. Generally speaking, the highest default rate on these loans is within the first year. If a borrower has made all payments on time for a year, the chance of default goes way down. Given that fact, many investors like to search the resale platform for high interest notes that are about a year old and which have perfect payment records. I can buy one right now that has a yield to maturity of 22.51%. At one time I may have bought that loan, figuring that if I got 22.51%, what did I care if the seller made something too. However, I learned that this is a way to lose money because that loan is offered at a 4.64% mark-up. The current principal and interest balance on that note is $22.63. The asking price is $23.68. Interest the next couple of months will be $0.48 per month. That means it will take more than two months to break even. Since borrowers can repay the loans anytime without penalty and because Lending Club collects 1% of any payment as a fee, it will probably take at least four months before you would be in the black if the borrower paid the loan early. If the borrower has improved his/her credit rating since taking out the loan, it is likely they will try to get a different loan at a lower interest rate. In short, the higher the premium you are paying, the greater the chance that an early payoff could leave you in the red rather than in the black.

Invest in Late Notes

Lending Club allows investors to sell notes that are overdue; Prosper does not. Of course, in order to get someone to buy an overdue note, you have to discount it. Some bloggers have claimed to be able to make money purchasing these notes at a discount. While some (or many) go bad, they get enough winners to make it worthwhile. If you are willing to study the odds, crunch the numbers and spend enough time reviewing the notes that are for sale, you may be able to make some money following this strategy, just as some stock traders are able to make money trading options on margin. For most people, the greater chance is that you will lose money. Play if you will with a little bit of money, but consider this to be gambling, not investing.

Sell Your Late Notes for too Little

Lending Club publishes statistics showing the percent of notes that end up going bad at each level of lateness. Generally sophisticated buyers will only purchase notes discounted that much or more. Some investors are more comfortable unloading late notes, and will discount them until they sell. If it helps you sleep better at night knowing that you may have let a note go too cheaply, but at least you won't lose it all, then go for it. However, statistically speaking, in general you are better off waiting out the defaults if you are not able to sell the late notes at a discount that doesn't exceed the expected default rate.

Conclusion

Peer-to-peer lending is, from what I can see, a profitable way to invest money, but it is not risk-free. Like most other investments, the more risk you are willing to take, the more money it is possible to make, but the bigger the chance you will lose money. Consider whether you are willing to put the time into becoming an expert on statistics and credit models. If you are not, buy the platform and let the law of averages work for you.

*Part of Financially Savvy Saturdays on brokeGIRLrich, A Disease Called Debt and Femme Frugality*