As every p2p investor should know each month we receive principal plus interest on the notes in our Lending Club and Prosper accounts. But did you know your effective interest rate on each note goes down each month?
In fact if you invest in a loan paying 12% the only time you receive that interest rate is in the first month. Every month after that you will receive less than 12% on your original investment. Allow me to explain with a table.
The table below shows the payment schedule on a hypothetical investment of $50 in a loan paying 12% interest. Now, I have not taken into account the investor fees that Lending Club and Prosper charges – they will take a very small portion of each payment. But this table illustrates the point I want to make which is a constantly reducing return on your original investment.[table "20" not found /]
As you can see at the end of the first year the interest on your initial investment of $50 has dropped to $0.37 and which is an annualized return of around 8.9% on your original investment. And by the end of the second year your return on your original investment has dropped to 4.8% – well under half your original rate of 12%.
P2P Lending is not a Traditional Fixed Income Investment
For many investors this may not be news but new investors often consider their Lending Club or Prosper investment a traditional fixed income investment. But this is not the case. If you had invested $50 in a 3 year CD paying 12% (obviously an impossibility today) you would have received total income at the end of three years of $18.
But with your p2p lending investment the income is roughly half that. The total interest earned on this hypothetical $50 investment is around $9.76. To return this amount from a CD-type fixed income investment then your interest rate would only need to be 6.5%.
It is always important to remember that you are receiving principal and interest payments every month. Every month your principal balance is reduced. Once that principal is back in your account it no longer is part of the ROI calculation.
This is why it is important to reinvest your cash if you want to maintain the highest possible ROI. Otherwise all that principal will just end up sitting in cash thereby reducing your effective ROI. And if you let your cash sit in your account for an entire three-year loan term you will earn around half the stated interest rate of your original investment.
[Update: As Louis pointed out in the comments section in the above example you do always receive 12% on your principal balance. It is just that the principal balance is being reduced every month, so the total interest received is reduced. I hope that is clear.]