The popularity of investing in consumer loans is growing at a tremendous rate. During a time when most fixed-income investments, such as CDs, Treasuries and investment-grade corporate bonds, offer paltry yields fewer than 5 percent, consumer loans to individuals with superb credit scores can provide a significantly higher interest rate to investors. For example, the author was able to find several 3 year consumer loans to an individuals with a credit scores over 740 that pay an interest rate of 9.25 percent. The appeal of these high-interest rates is obvious. Consumer loans (called peer-to-peer loans by many) are available for investment via several companies; however Lending Club is the clear leader in the space. Lending Club facilitated over $200 million in new loans in September versus the number two player in the space, Prosper, with less than $40 million.
This article will describe in detail how consumer loans work. First, there are not any mutual funds or ETFs that enable you to purchase this asset class, yet. Investors buy Notes backed by payments received on the actual loans. While the analogy is not perfect, you can think of investing in consumer loans as similar to buying individual bonds versus buying a bond mutual fund or ETF.
The opportunity to buy consumer debt is not yet available through traditional stock and bond brokerage firms. To invest, you need to open an account directly with Lending Club or Prosper. The consumer debt purchased via one company cannot be moved to another platform, so the choice of where to open an account is very important.
The Keys to Understanding Consumer Loans
Loans versus Notes
Creditworthy borrowers go to Lending Club to request loans between $1,000 and $35,000; however, a single investor does not have to fund the entire amount, nor is this recommended. Investors can invest a minimum of $25 in a particular loan when it is created. Some loans are funded by hundreds of investors. Each of these investors owns a note, which represents a portion of a specific consumer loan.
Term and Maturity
Lending Club Notes are available in three- or five-year terms and can be held till maturity or sold at any time. To pay back the loan, the borrower is required to make 36 or 60 equal monthly payments, with each payment comprised of interest and principal repayment. While the dollar amount of each payment should not vary, the composition of interest and principal being paid will vary month to month. At first, payments will be mainly interest, and by the last scheduled payment, the amount will be almost entirely principal repayment.
Maturity in the context of fixed-income investing refers to the point in time when interest and principal is scheduled to be fully repaid. Typically, this is done with a large lump-sum payment of the entire principal amount of the loan. Lending Club loans don’t have this large payment at the end, so the word maturity may provide the wrong connotation.
Interest Rate and Grade
Unlike credit cards, which charge everyone the same rates regardless of their credit, Lending Club uses risk-based pricing. Lending Club assigns each loan a grade from A to G. The rating of the loan is primarily based on Lending Club’s analysis of the risk that the borrower will not meet his or her obligations to pay back the loan as scheduled. So borrowers with the highest credit quality pay the lowest rates (A grade), and those with lower credit quality pay higher rates (G grade). It should be noted that Lending Club rejects many loan applications because they are too risky. Within each letter rating, there is finer calibration of risk using a one to five scale. For example, B2 is a better rating than B4.
There are two other major factors, not directly linked to the probability of repayment, which can impact the rating of a loan: term and loan size. Five-year loans will receive a lower rating than otherwise identical three-year loans, and a large loan may have a lower grade than a smaller loan from the same borrower.
The Lower the Rating, the Higher the Interest Rate
The highest-rated loans (A1) offered by Lending Club currently charge a fixed interest rate of 6.03 percent, while the lowest-rated loans (G5) charge 26.06 percent. While the difference in interest rates between these two ratings is more than 20 percent, that does not mean that the return on investment will be nearly as wide, or that it will differ at all. The A-rated loans are predicted to have an extremely low rate of non-payment, while G-rated loans are expected to have a much higher rate of non-payment by the borrower. Historical results show that the difference in annualized rate of return between A-rated (1-5) and G-rated (1-5) loans is less than 6 percent, with the A-rated loans having a net annualized return of 5.48% versus 11.40% for G-rated loans.
Taxes and Types of Accounts
As loans are repaid, the Notes generate interest income for the holder.They will not generate capital gains or losses if held to maturity.
If a Lending Club loan is not paid back in full (assuming at least one payment is made), the loan will generate a mixture of interest income and a short-term capital loss for its note holders.
If an investor follows a “buy and hold” investment strategy, investing in Lending Club should, if historical numbers hold true, provide a significant amount of interest income, and a much smaller amount of short-term capital losses. For most tax brackets, interest income is taxed at a higher rate than dividends or capital gains. As a result, many investors (approximately 15 – 20 percent[k2] of retail accounts by dollar amount at Lending Club) open tax advantage accounts (traditional or Roth IRA) with Lending Club.
Disclosure: The author is a Lending Club client and serves as the publisher of Learn Bonds, a publication in which Lending Club is an advertiser.