Most of my friends know I am involved in this peer to peer lending thing. Many think it is strange and they don’t really understand it. Others just think there must be some catch to earning such great returns and dismiss it. But some people are curious and decide they want to give it a try.
This was the case with a friend I had lunch with last week. She proudly told me she had just made her first p2p lending investment. After chatting with me some months ago she had decided to take the plunge and transferred in $5,000. She was fully invested in….get this….eight different loans at an average investment of $625 per loan. I just about fell off my chair.
Now, she hadn’t spent much time reading my blog, unfortunately, because otherwise she would have known what a really bad decision this was. With a $5,000 investment she should be invested in a minimum of 100 different loans, preferably 200 loans. So what made her think it was ok to invest in just eight loans?
The False Sense of Security of the Projected Return
Above is a screen shot of the Lending Club summary page you receive when you have created an order and are about to place an investment. Here the average interest rate of the loans in this investment is 14.65%. There is an expected default rate of 2.61%, an investor service charge of 0.7% which leaves a projected return of 11.34%. My friend glanced at this screen (it was a Lending Club investment) and thought it meant if this particular loan defaulted she would still receive a return of 11.34%.
Now, when you invest in a loan on Prosper (see the screen shot to the left) you are presented with an effective yield, estimated loss and an estimated return. But you can see the asterisk here and if an investor bothered to read the fine print they would realize that this is an estimate based “on a basket of loans with the same characteristics as this listing.” On Lending Club there is no such asterisk or explanation.
I realize you cannot stop people making bad investment decisions but maybe there should be a warning or something for investors like my friend when they are making an unwise decision. But with all the SEC restrictions both Lending Club and Prosper are restricted from giving investment advice so a warning like this might fly in the face of that.
Getting back to my friend. When I asked her why she only invested in eight loans she responded that she didn’t want to spend all day reading the loan listings. She was looking at the listings one by one and deciding whether to invest or not based on what people said in the loan descriptions. She felt attracted to certain loans and wanted to help these people so she put in a significant sum comforted by the projected return number.
We have agreed before she puts more money into p2p lending that she will call me and we will walk through the investing process together. For now, I will probably recommend she put these loans up for sale on the trading platform. She will likely have to take a 3-5% loss on them because large notes are difficult to sell on Foliofn. But that is going to be easier to recover from than a possible default that could see her portfolio take a 20% hit.
Now, I am sure that she is not the first investor to misunderstand what projected return means and she likely won’t be the last. Are changes needed here? I am interested to hear what you think.