Investing in peer-to-peer loans can provide you double digit annual returns. However, you need to be prepared for defaults. Many borrowers aren’t going to pay off the full amount they owe. Ironically, a large number of defaults may be a sign that you’re investing correctly.
What is a peer to peer loan?
In January, I started to invest in peer-to-peer loans. Peer-to-peer loans have recently become extremely popular with both investors and borrowers. The borrowers in this case are US residents that need money for paying off credit cards, financing a medical expense or improving their house. General speaking, the borrowers are trying to get an interest rate which is below what they would have to pay to a credit card company. Like a mortgage, these loans are amortizing, meaning that the borrower makes regular payments of interest and principal.
Peer-to-Peer loans can be financed by many lenders like myself. I can invest in these loans in $25 increments. In fact, the two main companies that facilitate the loans, Prosper and Lending Club , suggest that investors diversify among several hundred loans. I am currently invested in 816 individual loans.
Late Payments & Defaults
Almost ten of my 816 loans are not making their regularly scheduled monthly payments.
Number Of Loans
Current With Payments
Less Than 30 Days Late
Between 30 and 120 Days
A default on a loan is one in which the borrower hasn’t made its required payment in 120 days. This definition is important because the peer-to-peer companies don’t write off the value of a loan, and subtract it from the value of one’s portfolio until it defaults. A large portion of the loans which are late 30 days or more will default.
In my case, I don’t have any defaults because the loans in my portfolio are just reaching the 120 day mark. Up until now, even if a person borrowed money and never made a payment it would not have shown up as default. I expect to have a couple defaults over the next 30 days.
My Initial Reaction To Late Payments Was To Question Investing In Peer-To-Peer Loans
In January, I invested in several hundred loans. By February, I was already seeing that a couple of the loans had missed their first payment and were officially late. While I knew that a number of loans would default, I wasn’t prepared for the late payments to occur so quickly.
I asked myself: Did I make a mistake investing in peer-to-peer loans?
Did I make a mistake investing in peer to peer loans? No.
When I saw that the first couple loans were late, I feared that there would be an avalanche of late notices to follow. That never happened. In fact, some of the loans that were initially late resumed a normal payment schedule and were brought up to date. Most of the loans that I have invested in now have at least a 3 month history of making payments. Right now, around 1.25% of my loans are currently late. If all the loans that are currently late ended up defaulting, my portfolio would be still be returning around 11%.
Peer-to-peer loans pay exceptionally high yields because of the risk of default. The loans that I invest in pay an average interest rate of around 16%, or about 15% more than a Certificate of Deposit (CD). While a CD is insured by FDIC or NCUA, there is no guarantee that a peer-to-peer loan will get paid. Not only is there is no guarantee of payment, the rate of default (percentage of loans that default) could be very high. If the economy goes south, the default rate could dramatically rise. Investors generally don’t like both risk and uncertainty. To compensate for these factors, peer-to-peer loans have much higher expected return than safer investments.
If defaults did not occur with some frequency, peer-to-peer would not have such a high expected return.
Why do peer-to-peer loans seem more scary than other high yield investments?
Most investors that like high-yield investments, invest through a mutual fund or ETF. These funds hold dozens or hundreds of bond issues. When a bond issue in the fund defaults, there is no announcement. The funds NAV (net asset value) may get adjusted to reflect that bonds it holds are now less valuable. However, there can be many reasons for a fund’s NAV moving up and down including: interest rate moves, credit rating changes, and defaults. Historically, around 4% of high yield bonds default during a year. A high yield bond fund containing 200 bond issues should have around 8 defaults per year. The investors in a bond fund may have no idea if the bonds in their fund are defaulting. Defaults do factor into a funds overall performance, however, its backed into the performance with many other factors.
Where defaults are hidden from view with bond funds, defaults and late notices are completely visible and transparent. When you invest in peer-to-peer loans and properly diversify among a couple hundred issues, you will get individual late and default notices. Because this process is visible, it seems like defaults are more common and rampant than other investments.
What should you do when you see a default or late notice in your peer-to-peer account?
In most cases, the correct answer is nothing. Here are a couple tips that will make it easier to sit on your hands.
1) If you know that each loan only represents a tiny fraction of your portfolio, you will be less likely to have a reaction. Diversify among several hundred issues.
Since I own parts of 800 loans, each loan equals less than 0.2% of my portfolio. When I see a default, I say to myself that the loss is very small.
2) I analyze the worst case scenario. I assume that all the loans that are late will default. I subtract the amount from the value of the portfolio and calculate my returns.
Even under the worst case scenario, my returns are over 10%. I say to myself that its a good investment even when including defaults.