Many investors have the goal of building up their nest egg and living off the income it generates in retirement. Unfortunately, the low interest rates available on most fixed-income products mean this goal often becomes a distant dream. An investor buying fixed-income products yielding 2 percent a year would need to have $2 million in their portfolio to generate a pre-tax income of $40,000 per year—far more money than most investors have saved.
There is another option that many investors have not considered that can pay a substantially higher interest rate: Investing in consumer loans available through companies like Lending Club and Prosper. For background on consumer loans (often called P2P loans), read this primer.
Consumer loans have attractive yields
Compared to certificates of deposits (CDs), Treasury bonds, or even investment-grade corporate bonds, consumer loans have high yields.
|5-Year Corporate Bond – A Rated||2.17%|
|60-Month Lending Club – A5 Rated Loan||8.90%|
* the Corporate Bond does not pay principal back until maturity; however, the Lending Club note pays back principal throughout its term.
Because corporate bonds and Lending Club loans are not backed by the federal government, they have a higher risk level.
Factors that affect the return you can generate from Lending Club loans.
The return you can generate from Lending Club loans depends on the interest rate on the loan and the amount of non-payment by borrowers.
You know in advance the interest rate of the loans you are investing in. The interest rates on loans depend on the term of the loan and the loan’s risk rating, as determined by Lending Club. While interest rates on Lending Club loans currently range from 6.03 percent to 26.06 percent, those investing with the primary goals of protecting their nest egg and consistently generating income will likely want to focus on loans in the lower part of the range.
The amount of non-payment by borrowers will impact the performance of loans and cannot be known with certainty ahead of time. Lending Club has a tremendous amount of information about how loans of different grades have performed. Historically, A-rated loans (those considered to be the least likely to default) have produced returns of 5.19 percent per year. G-rated loans (those considered the most likely to default) have produced returns of 9.58 percent per year (as of 2/1/14).
Of course, the old caveat “past performance does not guarantee future results” applies. If the economy was to go into a prolonged recession or depression, the numbers could be very different. One assumption held by many people in finance is that higher-quality debt is hurt far less in difficult times than more risky debt. In other words, while G-rated loans pay more now, a very reasonable assumption is that the top-rated loans (A and B) would have more consistent returns during bad times.
How much can one expect to withdraw monthly from a portfolio of Lending Club loans without depleting the account balance?
A person looking for consistent performance will likely gravitate toward a portfolio consisting of A and B loans. In the current environment, I believe that it is not unreasonable to expect that a portfolio like this could produce an annual return of about 6.5 percent. On a $500,000 portfolio, a 6.5 percent return would equal $32,500 per year. If we divide the $32,500 yearly payment by 12, we can see that an investor would be able to withdraw around $2,708 (pre-tax) from their account each month, without the account’s value dropping significantly. Combined with income from Social Security, people in many areas could use this amount to live a middle-class lifestyle.
Some considerations to keep in mind
Consumer loans provide monthly cash flow – One of the nice features of consumer loans is that the borrower makes monthly payments. Because cash is coming into the account on a very frequent basis, you should be able to withdraw modest amounts regularly without needing to sell any loans.
Don’t withdraw all the payments your account receives – Unlike a normal bond, which pays interest until maturity, Lending Club loans work like a mortgage in which the loan is being paid down over time. This means that the monthly payments you receive contain both your interest payment and a portion of your original investment in the loan. If you withdraw all the payments your account receives, both your account balance and interest income will start rapidly moving toward zero.
Automatic disbursements of funds – Lending Club enables individuals to open up an IRA. With IRAs, you can have funds sent from your IRA to your bank account on a monthly or quarterly basis. Unfortunately, if you have a taxable account you will need to manually request withdrawals.
Don’t put all your eggs in one basket – I don’t believe any financial planner would recommend putting your entire portfolio in one thing. This applies to consumer loans as well.
Why could my grandparents live off the interest on their U.S. government and municipal bonds?
The short answer is that U.S. interest rates have gone down significantly over the last three decades. Below is the chart of the 10-year Treasury, which is considered the most important interest rate measure in the United States. Thirty years ago, the 10-year Treasury provided an interest rate of around 12.5 percent. Today, the 10-year interest rate is hovering around less than 3 percent, or less than a quarter of its rate 30 years ago.
“Disclosure: I am a Lending Club client and an editor of Learn Bonds on which Lending Club is an advertiser. This blog post contains several sponsored affiliate links and/or ads for Lending Club. If you click on a link or open an account through one of these links, I may receive a small commission from Lending Club. Additionally, I receive compensation from Lending Club for writing blog posts about Lending Club’s services.”
About Marc Prosser
Marc Prosser is the Co-Founder of Learnbonds.com and an active investor in P2P Loans. He began researching the bond market after making an angel investment in iTB Securities, a broker-dealer that has been built an active trading bond platform for retail investors. Prior to becoming an entrepreneur, he was a pioneer in the forex trading space and the first employee and Chief Marketing Officer of FXCM between 2000-2010.