Peer to Peer Lending: Neat Idea, Bad Investment

I first learned about peer to peer lending almost two years ago when I came across an article about Prosper.com. I immediately got fired up about how the power of eBay was going to be brought to the world of finance. I could not wait to dive in and make my first loan. But I didn't. I never made a loan, and here is why: peer to peer lending is a bad investment.

I know lots of people in the personal finance blog world are hyping up this paradigm shift in lending. They write post after post about how it works, how to get started, and how they personally invest in peer to peer. Now for the big shocker... the bloggers are getting paid by Prosper and Lending Club (the two primary companies in the field). I'm not trying to say that everything they have posted is tainted and trying to mislead the reader, but their motives are not 100% pure either. Some bloggers are more honest or at least less naive about these companies and their product, and others seem to write nothing but a puff piece full of hype. Some bloggers are very clear and up front about how they are paid for advertising, referrals, and in some cases pay-per-post. Others stick to the marketing material and disclose that they get paid with a referral, but do not offer a balanced review to go with it. None of the reputable, best-in-class bloggers have done this, but some even hide the fact that there is any financial relationship with these vendors, all while collecting sizable cash by steering their readers to a poor investment.

Why is peer to peer a bad investment? There are several reasons. The first and most obvious is the default rates for borrowers. A default is when someone you loaned money to stops paying, and obviously that is terrible for the health of your investment. While there are ramifications for borrowers who default, it is somewhat limited. First, their credit score will go down. We all know the importance of a good credit score, but many people do not know or do not care. Next, a collection agency assigned by the vendor (term I will use for Prosper.com or Lending Club) to get back your money. This is not the mafia in old New York, so there will be no broken knees or threatening visits for defaulting. Laws are very strict about what the collection agencies can do, and it isn't much. These folks also charge a fee for their services that comes out of any funds the collect. Finally, there is no real property that secures the loan. It is not like a mortgage where you can take their house or a car loan were you can take their car. Compare this with corporate bonds which are backed by the real assets of a company. If they default a judge can liquidate the company and return the proceeds to bond holders. That will not happen with a peer to peer loan.

So what is the real risk of default. It happens rarely right? Unfortunately that is not the case. For the highest rated AA loans on Prosper.com 1.75% of the investing return was eaten up by defaults on average. In total 0.15% of all AA loans had stopped payment and another 1.66% were late. That means for about 1 out of every 666 loans the borrow has completely stopped paying the loan and 1 in 60 are late. Remember this is for the creme de la creme of borrowers, those rated at AA.

Now I'm going to rattle off the amount of return lost to defaults for the other credit grades: A - 4.76%, B - 7.45%, C - 10.78%, D - 10.58%, E - 16.52%, HR - 21.48%. Those numbers seem pretty high right? To make any money at all you have to charge some pretty stiff interest rates, even for moderate risk borrowers. The actual average returns for loans in each credit grade are as follows: AA - 8.14, A - 6.95, B - 5.92, C - 4.77, D - 7.83, E - 4.49, HR - (0.74)%. Those returns do not look that impressive to me. I also learned in basic Econ 101 that as the risk of an investment goes up, an investor should earn a higher return to compensate. It seems that instead, as risk goes up the real return goes down. There is no risk premium for loaning to poor credit borrowers. As such, DO NOT DO IT!

Peer to peer loan returns aren't better than the average return of the stock market. They aren't better than the average return of many corporate bonds either. In fact, you can get a bond from Toyota that is AAA rated with a yield of 7.653%. This bond is backed by hard assets of the company. Why would you mess with peer to peer lending?

Here is an even scarier set of statistics, the probability of default on an individual loan from Prosper.com: A - 1 in 189, B - 1 in 85, C - 1 in 50, D - 1 in 41, E - 1 in 20, and HR - 1 in 18. What this means is that with every single loan you make, you have that chance of loosing nearly 100% of your investment when a borrower defaults. The values for net default, which is what is lost after including the funds recouped from those how default hardly improves over the default rate. The data shows that in default even with the vendor's best efforts to collect, on average 80% of the defaulted loan is lost. Are you willing to take those odds with an investment? I'm not.

When I quote a return of say 8.14% on average for A loans, that is over the entire sample size of A loans made. You are in no way guaranteed that return unless you fund around 100 times the expected number of defaults. That would be diversifying into many loans to reduce the risk. If you funded 189 loans you are most likely going to have exactly one default and your results will be very similar to the average. If you fund say one or two or even twenty, there is a chance, albeit small, that you will have one default and your investment would perform much much worse than the average. One default in a small or moderate loan portfolio kills all of your returns. In other words, it takes a huge amount of money to make peer to peer lending a reasonable proposition. A starting portfolio would need 189 * $50 or $9450 to have sufficient diversification to have results that matched the average return. Invest less and you run the risk of substantially lower returns and also little likelihood of out-performing the average either (again despite your higher risk).

Another factor will drastically drag down returns from peer to peer lending. The way the system is structured, about half of the time your money is actually sitting on the sidelines not earning any return at all! Here is why, when you loan out say $100, each month you will get a tiny amount returned in principle and interest. This amount is far too low to fund another loan so it sits there collecting no return at all. This process continues for a very long while until you have $50 ready to invest in a new loan. This will also happen when you fund a loan and the borrower pays the loan back more rapidly than anticipated (called prepayment risk). This will sideline even more of your money very quickly and again keep it from making any return. What you will find is that your real annualized returns are far below the rate at which you make your loans. My estimates say that for small and moderate size portfolios your real return on capital (APY) is about 1/3 lower than the rates at which you make your loans (APR).

So here is an example: If you make a loan to a AA borrower at 8.69% and pay fees of 0.48% you will be left with a rate of 8.21%. Now you must realize there is some probability you will loose everything from default because you are not diversified, but ignoring that risk for a moment, assume after 3 years your whole loan has been paid back. Now it is time to calculate your annualized return and surprise, surprise, it will work out to be approximately 5.42%. Where did all of the return go? Well, the the opportunity cost of having your money on the sidelines waiting to be loaned ate it all up. If you factor in the real discounted risk of default, fees, and opportunity cost, your annualized return is more more like 4.26%. This drag on your investment can be mitigated somewhat by investing a large amount of money so that each month you are able to initiate a new loan using your returned capital. In this way you can keep more of your money working at any given time. This would require about $7500 to be able to start a new loan every month. Oh, I also forgot to include taxes which knock off another 25%.

This whole system seems neat and innovative but lenders almost universally would all be better off in corporate bonds. Honestly, almost any other investment vehicle is going to beat peer to peer lending. I started out very excited and the more I learned, the more I ran the other way. It is possible that one day all of the kinks can be worked out and the system will be better for both borrowers and lenders. I hope this has saved some people a great deal of frustration when they find their returns always lagging and they can't figure out why peer to peer is performing so poorly. Thanks for reading; comments are always welcome.

* The data used for my calculations is from June 1 2006 to Jan 14 2008 from Prosper.com if you want to recreate this yourself.