Dateline: Tbilisi, Georgia
I have mixed feelings about the collaborative economy. As an anarcho-capitalist, I’m all about reducing government involvement in our lives. However, that doesn’t always lead to an aversion to institutions.
Internet business gurus can’t stop talking about the revolution of peer-to-peer commerce and it’s disruptive power over “inefficient institutions.” According to them, the collaborative economy will put hotels, taxi companies, banks and almost everyone out of business.
In reality, I’m not too concerned about whether they will or won’t.
I’m not going to jump on the bandwagon to praise all crowdfunding, peer-to-peer and Uber-like services. Instead, I’ve decided to take a hands-on, one-by-one approach to researching many of these much-ballyhooed tools. After all, it’s not about the collaborative economy in and of itself, it’s about the value-added.
I’ve already discussed the potential gains you could make buying foreign real estate to rent to tourists on Airbnb. I’ve also invested in properties in the US through Realty Shares, just to give my readers a personal review. And, while I’m not completely in love with Bitcoin, I see the value of having a decentralized currency.
Recently, I decided to sit down and discuss one of the more interesting peer-to-peer programs with my client, Robert Spencer. Robert has been incredibly successful investing in peer-to-peer (P2P) lending sites like Lending Club in the United States. I knew that his insights could be of great value to our readers, and our conversation did not disappoint.
Of course, our discussion was not focused on whether such sites will completely disrupt banking institutions. Instead, Robert gave me an insider’s perspective on how to use such a platform to make returns as high as 27%. Today, I’m sharing his expertise with you.
What is P2P lending?
In it’s most basic form, peer-to-peer lending is as simple as one person lending money to another. It can be as informal as a friend asking you for some money and promising to pay you back. However, the P2P lending that has gained traction in just the past decade is much more formal and lucrative.
Bypassing official financial institutions, P2P lending sites cut out the middleman while still providing a level of order that enables individuals to borrow and lend money. It used to be that someone lending money — say $10,000 — would be on the hook for the whole investment. If the borrower defaulted, the entire $10,000 would be gone. A rather risky investment.
Now, however, these lending sites break down each loan into pieces as small as $25 a note. So, instead of one person backing the loan, a $10,000 note can be split between 400 different investors. If the borrower defaults, each investor will only lose out on $25.
Under this system, P2P lenders can spread out their investments across a wide range of borrowers, decreasing their risk. On most lending sites you can see the person who is borrowing the money, why they are borrowing and their credit score. And, in each case, you choose how much you will lend them.
You are then repaid on a monthly basis on the money you lent, with any interest due on the loan(s) you have made.
The biggest sites and Robert’s choice
Besides Zopa, Europe has two other prominent lending sites: Mintos and Twino. Americans can use these sites, but only if they can get their money to Europe. In most cases, this means that you will need a European bank account. While Robert has never invested through these sites, he has a friend who uses Baltikums Bank in Latvia and deposits his money in Mintos from there.
There’s also a P2P site that uses Bitcoin. However, Robert had not used this site and did not have any connections who had used it. As such, he was not ready to make a recommendation. Still, those interested in Bitcoin are free to investigate the site on their own. They tend to express the loans in US dollars, but they usually make payments in Bitcoin.
Robert chooses to invest through Lending Club for various reasons. For one, he is located in the US, narrowing his choices down to Prosper and Lending Club. (Note: there are other sites in the US, but these are the largest two.) Although the returns are somewhat similar with Prosper, LendingClub has done more loans — currently over 18 billion, in fact.
According to Robert, they also do a more consistent job running preliminary checks to make sure people are who they say they are and that you’re making a legitimate loan. Prosper does preliminary checks as well, but Robert noted that there was a recent filing in which Prosper admitted that they don’t do it 100% of the time.
And, though they have tightened up their standards since then, many of Robert’s contacts experienced high default rates during their first experiences with Prosper in 2008. Some didn’t make any money in that period of time. To be fair, LendingClub was very new at the time, so it’s difficult to make an apples to apples comparison. Nevertheless, Robert has chosen to invest primarily in Lending Club and has done very well.
Peer-to-peer lending guarantees
Between these different lending platforms, there’s a huge range in what’s available as far as guarantees. In the US, LendingClub and Prosper don’t make any guarantee that you’ll get your money back.
However, they do provide statistics (especially Lending Club) that show at what point everybody ends up making money. The statistics indicate that at roughly $10,000 invested, spread out over various loans — ideally sticking to $25 per loan — they don’t have anybody losing money.
The big problem that people run into is when they choose to invest more than $25 in any given loan. It is easier to manage your investments if you invest larger amounts because there are fewer loans to start. However, you are really taking a big risk that way.
One thing that LendingClub promises to lenders is that your losses will be limited to the amount you invest in any one note. As long as you only invest $25 in any given note, you’ll never lose more than $25 on a loan.
European P2P lending sites, on the other hand, offer more guarantees. Europeans tend to have more socialist preferences, which means they demand more guarantees. For example, Zopa makes actual guarantees that you will get your money back.
The downside to this is that borrowers are paying at a much lower percentage — somewhere between 3.5% and 6%. This, of course, means you get much lower returns. Mintos charges higher interest rates, but returns are only up to about 12.75%.
In comparison, Robert has been able to get returns as high as 27% through LendingClub.
What are the returns?
LendingClub and Prosper offer a wide range of interest rates and returns, depending on the level of risk involved. If you choose to invest in individuals with the highest credit ratings, returns are as low as 5%. Ideally, this is where you will have the least defaults, but it comes with the price of lower returns.
Beginners often start with A, B and C grade loans to be safe, but they typically get a much lower return. They’re lucky if they get over 10%.
Robert, on the other hand, only invests in the E and F grade notes and consistently makes somewhere between 20-27% returns on his money annualized. He explained that he’s not trying to get the absolute highest returns because the higher you go in returns, the riskier the loans will be. In fact, looking at the statistics page on Lending Club, once you go into G notes (the worst credit scores) the returns drop due to the higher default rate.
With his strategy, Robert said that his returns typically ride up around 27%. The way LendingClub works, if somebody is late paying, the site will show what the effect will be on your return if the borrower never pays up. As such, the number can bounce around a little bit. Nevertheless, Robert’s returns always stay above 20% and will occasionally peak a little above 27%.
Overall, his returns have been very consistent.
Robert pointed out that some people hate the stock market because of the ups and downs. The solution for some just might be peer-to-peer lending. Perhaps not as consistent as the .01% from your bank savings account, but returns from P2P lending stay very stable.
How to keep your returns high
The question, then, is to know how Robert keeps his returns high. Fortunately, Robert says that it is not primarily a function of how much you have invested. Rather, it’s a function of how quickly you can get your cash back into the next note.
With LendingClub and Prosper, you will receive all the interest that’s due, plus some of your original investment, each month. The amount returned will depend on the length of the loans you invest in. LendingClub offers three and five-year notes, so you’ll either receive 1/36th or 1/60th of the principal amount.
Once you have received that money back, Robert explains that the big thing is to keep that money moving. If you’re going to invest consistently, you’ll want to get that money into circulation again as quickly as you can. If your note average is 24%, your yield will actually be around 27% if you can keep that money working.
Though keeping your returns high largely depends on continually moving your money, it helps to have a certain amount invested. For instance, suppose you’ve invested $250 and aren’t investing any additional money each month. It would take two to four months to generate enough in return payments to invest in the next $25 note.
Once you’ve invested around $1000, the interest and principal repayment tends to keep the money flowing quick enough that you can keep your returns up.
Protecting your money from the risk of default
In Robert’s experience, the default rate in LendingClub is extremely low, especially with the selection criteria that he uses. (More on his criteria later.) The bigger problem he’s encountered comes when people actually pay off their note early.
He explains that he’ll go through the process of buying a note, but just three months later a certain percentage of those borrowers will qualify for a lower interest rate. Consequently, they pay off their loan and get a new one with a lower interest rate. It’s smart on the borrower’s part, but it does create a little extra work for the lender.
Still, Robert says that it’s good to see individuals with lower scores improve their credit through peer-to-peer lending. Even with these situations, he’s making the bigger money as the lender at the higher credit grades. For Robert, it’s just the cost of doing business.
Even with this cost, Robert has maintained high returns through sound risk management. His first rule is to keep any given investment down to the $25 notes. People are generally looking to borrow somewhere between $10,000 and $35,000 dollars, but since you’re only on the hook for $25 it makes things a little safer.
Statistically speaking, as soon as you can spread out your risk with any investment, you’re going to be much better off. With peer-to-peer lending, people will sometimes pay late, but at least by being able to spread out your risk it’s not an all or nothing proposition.
Robert’s loan selection criteria
If you have over $2,500 invested you qualify for the automatic investing option. With this option, you can push one or two buttons and the site will randomly find notes in the categories where you’d like them to be.
While this option is convenient, Robert likes to follow a more hands-on process. By manually selecting each investor, he can choose the notes that he believes will be best for him.
Robert said that his main selection criterion is to make sure he’s dealing with people who are trying to rehabilitate their credit. He explains:
There are home improvement loans where people are paying 27%, but I try to stay a away from those for the most part. I try to find people who are refinancing something, trying to improve their credit. That is probably part of the reason I have so many people who end up paying off their loan and moving on to a new loan. However, credit conscious borrowers — even though they’ve got a couple dings or they’ve gone through a bad experience — at least they’re trying. The few defaults that I’ve seen, typically it’s some type of new loan, whether they’re buying a car or doing a home improvement. You have to wonder at the wisdom of someone who is doing a home improvement loan and they’re paying 27%.
There are a few home improvement loans, he admits, that are more reliable. There are some situations in which people have to fix things in their house (i.e. fix the bathroom or go without). For the most part, however, it’s best to invest in people looking to rehabilitate their credit.
Peer-to-peer lending often serves people who are having a hard time getting funded through a bank. As such, you’re really providing quite a lot of value to these folks. By investing in their loans they are able to meet whatever needs they have and rehabilitate their credit as well.
How do I get started?
Knowing where to start all depends on what you can handle seeing on the screen. If you’re really timid and nervous, then you may want to start with A-grade loans. If you’re looking for higher returns, you’ll want to go straight to E and F grade loans. But it really just depends on your risk tolerance.
For example, one person could go in and invest in E and F grade loans and say “This is great! I’m getting a great return. Sure, I’m getting the occasional default, but my returns are still very high.” Someone else might experience the exact same scenario, see a default, get freaked out and assert, “It doesn’t work! I want my money back!” So determine your risk tolerance before deciding where to jump in.
In terms of the amount to invest, as mentioned, you can invest as little as $25. You can invest in the exact same loans that millionaires invest in. That’s what makes the platform so nice. Though you can obviously start with more, you could start with just one $25 note and still do well — as long as you intended to put in an extra $25 dollars every month, obtaining more notes over time. Just recognize that when you only have one note, it’s an all or nothing proposition.
Robert said that the minimal amount he would be most comfortable starting with is $250. At that amount, you will at least have 10 different loans so you can spread out your risk a little bit.
What are the taxes like?
The interest you receive from your loans is treated similarly to interest you’d get on a regular bank account. The downside, of course, is that interest is basically treated like normal income. In other words, it will be taxed at the same rate as the money you make at a job or anything of that nature.
There’s no way to change that unless you are a larger investor or part of a pool of larger investors. For instance, LendingClub will actually allow corporations to invest. In that case, the corporation has to have a minimum of $50,000 to make it worthwhile for LendingClub.
At that point, the corporation is making regular income from LendingClub and, if you had people investing in that, it would actually be a dividend once it’s handed out to investors. That way it would be a qualified dividend and it would get better tax treatment.
For non-US persons who want to invest in LendingClub, you can use this strategy. Unlike Europe — where you only need a bank account there to invest — you have to be a US person in order to invest in LendingClub. Even in the US there are still states where the inhabitants do not have permission to invest in LendingClub. They’ve almost got it to the point where everybody can, but it’s not at 100% yet.
P2P overseas lending
If you are currently living overseas, you can still invest in P2P lending sites. If your US state has approved such financial practices and you have a bank account in the US, there shouldn’t be a problem.
Since all lending is web-based, you can access the website and interact with it from anywhere in the world. Robert noted that if you are in a country that blocks access, you would need a special set up, such as a proxy or some type of VPN connection.
On the other end, if you are in the US and are looking to invest in P2P services overseas, Robert recommended a gold and silver dealer who does storage in Singapore, as well as P2P lending. However, the peer-to-peer lending is done on a much smaller scale, as it’s just a small piece of his business.
The way it’s set up, you would provide the entire loan. While this can be a challenge, the advantage to this particular structure is that the Singapore company is securing the loan with the gold and silver held right in their facility. Yes, an entire loan secured by bullion. If the borrower defaults, you end up with a small little stockpile of gold and silver in Singapore.
The best part, however, is that they’re still giving returns of 5-6%. While this is nothing compared to the returns you can get with LendingClub, it is a solid return for being secured. There are mortgages in the US that are under 3%, and banks still have to go through a difficult process to get the house if the mortgage defaults.
In the meantime, these secured P2P loans are backed by gold that’s sitting in a vault. It’s not a question of getting the gold so it can become yours, it’s just sitting in the storage facility. One day it’s the borrower’s, but if he can’t repay for whatever reason, the next day it’s yours.
Do I need an offshore Plan B with P2P lending?
There are two ways to approach going offshore with P2P lending. The first is to invest in peer-to-peer lending as discussed above. Robert, however, does not plan to do so for now. His returns are already high and no P2P lending service overseas compares with what he’s been able to get through LendingClub.
He said he used to sit down with a spreadsheet he’d made in excel and run the numbers to see what would happen if he invested the same amount of money with a different interest rate. As we’ve seen before here at Nomad Capitalist, after 20-25 years even a few percentage points can have a dramatic effect on the other end.
Knowing that, Robert plans to stay where he has the highest chance to maximize his return. He says that this has actually caused a lot of problems for him in the investing world because there aren’t a lot of places that will consistently pay you over 20% with a relatively well-managed amount of risk.
That does not mean, however, that Robert does not have an offshore plan.
He explained that when you get to the point where you have a nest egg big enough for someone to come after, it’s worth moving your money offshore — if only for asset protection. That doesn’t mean you can’t keep your balance growing through these sites in the US, but you don’t want to have it all in one place where it can fall prey to someone or something.
As Robert said, “I don’t care how safe something looks, you do have to have things moved around a little bit. It’s good to be diversified.”