The Basics of Peer-to-Peer Investing

Investing in Social Lending

Peer-to-Peer investing (commonly P2P) is the practice of investing money in notes of loans for borrowers who are requesting a loan without going through a traditional financial intermediary and who are unknown to the investor. This type of investing typically takes place online through online platforms, among which Lending Club and Prosper are the industry leaders. Personally, I have only had experience using Lending Club and I love the platform. However, this article is not intended to review either platform so here are some reviews that may help you determine which platform best suits your needs,

Put it Simply

Put simply, on P2P investing platforms a user can create an account as either an
investor or as a borrower. The borrowers are there to get some money while the investor is there with hopes of making money via interest from the loans.

The borrower is required to provide some fundamental information similar to what is observed by traditional financial intermediaries such as income, liabilities, rent/mortgage payment, current employment, length of employment, etc. Additionally the borrower’s credit report information is also shown such as the number of delinquencies, open credit lines, credit utilization, and so on. Given this information the investor is to intelligently purchase loan notes and collect monthly payments of principal and interest. Thus, in the simplest form, you as a P2P investor are a bank.

The Notes

Customarily each note has a set value, typically $25, and is held for a set period of time (the loan term) usually 3 or 5 years. When investing in a particular loan the investor has the option to purchase multiple notes of the loan.

For example, if a borrower intends to borrow $5,000 the loan is broken up into 200 notes. If desired, the investor can purchase all 200 notes and provide the full loan amount. If this were the case the investor is entitled all interest and principal paid on the loan. However, the investor is more likely to purchase just 1 or 2 notes pertaining to any one loan, and is wise to do so.

On average, investors experience higher gains and less volatility if they purchase just a single note for any particular loan. An investor who holds many notes of the same loan will lose more capital if the loan’s borrower defaults, if an investor holds a single note for many loans much less capital is at stake in the event of a default.

The notes are ranked by how likely the borrower is to default. The interest rates on these loans is determined by its rank, more risky notes will have higher interest rates while safer notes have lower interest rates. Many low risk notes will receive interest rates between 5-8% while some of the highest risk notes can fetch interest rates of 25%.

Personally, I have done ample research on the interest and default rates of the loans on Lending Club since its inception. The results can be found here and a convenient calculator to help estimate returns while factoring in defaults can be found here.

Because of this research, and my risk tolerance, I tend to use a hedging strategy where ~45% of my portfolio is higher risk notes earning an average of 20% interest and the other ~55% is split evenly between the lowest risk notes earning an average of 7% and mid risk notes earning an average of 12%.

Payments

Like most loans, the borrower is responsible for making a monthly payment to their loans. A portion of this payment will be interest and the remainder will be applied to the principal. Obviously, the amount of interest and principal each investor is entitled to depends on how many notes of that loan the investor holds.

In the example above assume the borrower borrows $5,000 for 36 months at an interest rate of 12%. The loan would be broken into 200 notes, $25 per note, and the payment would be $166.07. For the first payment, $50 will be interest and $116.07 will be applied to the outstanding principal. Since this loan consists of 200 individual notes each note will earn $0.83035, $0.25 in interest and $0.58035 principal, this is the amount an investor holding a single note will be paid the first month.

The interest will be the investor’s “paycheck” while the principal is the repayment of the borrowed capital. Since each note earns these amounts owning more than one note while increase the interest and principal received for a loan each month. The interest and principal paid each month belongs to the investor and is theirs to use for whatever they like, such as in reinvesting into more notes.

Trading Notes

Both Prosper and Lending Club use the Folio Investing platform to allow investors to trade notes of previously issued loans for whatever reason. Some typical reasons to sell your notes before they mature are the borrower has missed a payment and you want to receive something for your note rather than charging it off or you’ve recently purchased your notes but need to use the invested capital for something else.

The ability to trade notes on these platforms adds liquidity to the investment. Prior to this functionality an investor was ‘stuck’ with the notes until they mature or are charged off. Effectively, this made P2P investing more difficult since it meant not seeing a majority of you capital for a few years while it was slowly being paid back month after month.

Other than liquidity, trading notes allows an investor to salvage their return on investment (ROI) by getting cash for notes before they are charged off. Some traders on note trading platforms purchase late notes with hopes the borrower will eventually continue making payments. As many of these notes are sold at discounted rates, a note buyer stands to make huge returns from purchasing adequately discounted notes.

As a beginner, I recommend you start by buying notes when they originate and only sell notes on the note trading platforms, largely because purchasing notes, even if greatly discounted, is risky and will more often than note conclude in a loss of capital.

Defualts – Charge Offs

Occasionally some borrowers will miss payments and default on their loans. Sometimes the borrowers only miss a few payments then continue making the payments but most times the capital can be considered lost. When it has been determined that the borrower is likely to never commence payment the principal amount is charged off, which creates a loss for the investor. Other than attempting to sell the notes on a note trading platform there is little the investor can do about late payments and default loans. With this the risk of P2P investing is realized.

If an investor owns a small number of notes it is often the case that a default early in a loan’s lifetime will completely annihilate any returns the investor hoped to earn. Consider owning only 10 notes each pertaining to a different loan. For simplicity’s sake we’ll assume each note earns 8% interest and has a 36 month term. If no loans are charged off the investor’s account will realize the following (calculated with Note Calculator),

Account Value: 282.03
Interest Accrued: 32.03
Return On Investment: 12.8109%
Annual ROI: 4.2703%

a reasonable annual return provided the relatively low rate of interest. Now let’s assume a single note stop receiving payments in the 4th month of the term. Using the same Note Calculator and adding the default condition the investor’s account will show the following,

Account Value: 256.17
Interest Accrued: 29.31
Return On Investment: 2.4699%
Annual ROI: 0.8233%

A single default has nearly destroyed the entire return. If 3 loans in this portfolio default in the 4th month the investor will realize a loss with an account looking similar to,

Account Value: 204.47
Interest Accrued: 23.88
Return On Investment: -18.2121%
Annual ROI: -6.0707%

Now let’s look at losing 10 notes in the 3rd month if the investor had 100 different notes (same term length, same interest rate),

Account Value: 2553.91
Interest Accrued: 291.54
Return On Investment: 2.1566%
Annual ROI: 0.7189%

We can see the investor can lose many more notes and still realize profit, although the percentages of notes lost will stay nearly the same.

That being said, we can see that to mitigate risk in your P2P investing portfolio is to diversify a reasonably large some of money (~$2,500) across many notes (preferably 100 notes, 1 note per loan).

A diversification factor is key to risk mitigation for many financial institutions such as banks and insurance agencies. For example, it is very likely one person will total their car this month but it is unlikely that 10,000 premium-paying clients will all total their cars this month, thus an insurance agency can still buy someone a new car while turning a profit for the month.

Conclusion

In sum, P2P investing is an excellent way to diversify your investments outside of stocks, bonds, and real estate. However, it is key to invest a reasonable amount of money, $1,500-$2,500, to start so that a good mix of notes can be purchased, although this is not required (I started with $400). By diversifying your P2P investments in many notes with different interest rates you will mitigate the risk of losing potential gains in the event of a few notes being charged off. Furthermore, the active investor is wise to sell defaulting loan notes before they are completely charged off as this will salvage some principal and raise the overall return.

More information and some calculations and statistics pertaining to P2P investing can be found here.

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