Is there something wrong with debt that pays a 25% interest rate?Author: David WaringLast Updated: December 24, 2019 In my last article we talked about peer to peer lending, an investment which has averaged over 10% a year for the last 26 years. What we did not discuss however is that for those investors who are willing to take on more risk, the returns can be even higher.So is there a problem with debt that offers a 25% rate? The answer is, it depends how you are looking at it. Where do these high yields live?In unsecured US consumer debt. As discussed in my last article companies like Lending Club and Prosper have opened up consumer debt, which was once the domain of only the world’s largest banks, to individual investors.As the name implies, investors are making loans to people, not companies. The loans are not collateralized by any specific assets, such as a house or car. You are counting on the integrity of the borrower to repay the loan. However, if the borrower does not repay the loan, the lack of payment will count against their credit history affecting their ability to get credit cards and home loans.The majority of consumer debt loans are for debt consolidation; people trying to lower high credit card interest. The rates are designed to save the borrower 3-4% a year on their credit card debt. Typically loans are for amounts of less than $10,000, but in certain cases where the borrower has good credit, can go up to $35,000. The loans can be financed by one person or many investors in increments of $25.Where does the 25% Peer to Peer Lending Rate Come Into Play?The highest credit risk loan offered by Lending Club (rated G5 according to their internal rating systems) offers a 3 year interest rate of 24.89%. In the case of Prosper, the highest risk loan (HR) has an interest rate of 31.7%, or after fees just a tad below the legal limit in most states. Both companies suggest through their historical performance records that the highest risk (or high risk loans) provide the best investor performance. However, the actual return after including charge-offs (uncollected debt) is less than half the interest rates the borrowers are paying on the loans. Historical Return After Charge Offs is Closer to 12.5%Lending Club reports that from the firm’s inception till 3/19/2012 it’s G rated loans produced an average outstanding return to investors of 12.44%. Prosper has a far higher average return on its high risk loans, however, excludes loans issued before 2009.Lending Club reports that 90 of its 557 G rated loans defaulted, which means they did not make full payments. While about one in six loans did not pay, on average investors still made well over 10%. While far less than the 25% rate the loans pay, still not too shabby in an environment where even Junk Bonds are yielding significantly less than this. Why do I like this as a Potential Investment?In addition to the potentially juicy peer to peer lending returns, I think investing in unsecured consumer credit today, might be like investing in junk bonds in the early 1980s. Even financial professionals sometimes forget that early investors in junk bonds made lots of money. At the time, junk bonds were severely mispriced. The high yields did not accurately reflect the level or risk. Junk bond yields offered above market returns for two reasons:There was a stigma to investing in junk debt which decreased demand.The limited number of junk bonds available did not give investor confidence in their historical returns.As people made money investing in junk bonds, the stigma was lifted and more junk bonds were issued. At the same time, the above market returns disappeared.Is unsecured consumer credit in 2012 like junk bonds in 1982? Looking at the RisksThere are reasons to be cautious of the numbers provided by Lending Club and Prosper. The sample size of data is very small, each company only has data on about 40,000 loans. The characteristics of the people using the service today (particularly when you look at small segments of their loans) may not hold true in the future. Furthermore, most of the loans being tracked were originated after 2010 when the US economy had stabilized. If the economy was heading into another recession, default rates on the most risky loans they offer could skyrocket.In an interview with the CEO of Lending Club, Renaud Laplanche, I asked what would happen to charge-offs and returns if the US economy went deeper into a recession. According to his models, he thinks the two highest grades of loans (the lowest yielding loans) would be relatively unaffected. The charge-off rate on the highest quality loans would rise from 1.00% to 1.3%, producing an annual return in the 6-8% range. On the other hand, he could see charge-offs on the two lowest grades increasing greatly. After accounting for the increase in charge offs, the rate of return could be around 3 or 4%. If unemployment heads back over 9%, according to Mr. Laplanche’s projections, the higher rated and lower yielding loans would still provide an excellent return. The lower rated but higher yielding loans would still produce a positive return, but returns would fall substantially from their current levels. Throughout my interview with Mr. Laplanche, he consistently directed the conversation to the less risky loans / lower yielding loans. He wanted me to recognize that Lending Club was for serious investors rather than those attracted to double digit yields. Diversification is the KeyIts not that these are not dangerous loans, however, the huge interest rates currently OVERALL more than compensate for the losses due to non–payment. To lower the chance of your returns being severely impacted by the losses on a few loans, both companies recommend holding hundreds of loans, instead of just one or two. Both companies also make it easy to achieve that type of diversification.