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.
| Month | Payment | Principal | Interest | Balance | Cash Balance | % Return | |
|---|---|---|---|---|---|---|---|
| 1 | $1.66 | $1.16 | $0.50 | $48.84 | $1.66 | 12.0% | |
| 2 | $1.66 | $1.17 | $0.49 | $47.67 | $3.32 | 11.8% | |
| 3 | $1.66 | $1.18 | $0.48 | $46.49 | $4.98 | 11.5% | |
| 4 | $1.66 | $1.20 | $0.46 | $45.29 | $6.64 | 11.0% | |
| 5 | $1.66 | $1.21 | $0.45 | $44.08 | $8.30 | 10.8% | |
| 6 | $1.66 | $1.22 | $0.44 | $42.86 | $9.96 | 10.6% | |
| 7 | $1.66 | $1.23 | $0.43 | $41.63 | $11.62 | 10.3% | |
| 8 | $1.66 | $1.24 | $0.42 | $40.39 | $13.28 | 10.1% | |
| 9 | $1.66 | $1.26 | $0.40 | $39.13 | $14.94 | 9.6% | |
| 10 | $1.66 | $1.27 | $0.39 | $37.86 | $16.60 | 9.4% | |
| 11 | $1.66 | $1.28 | $0.38 | $36.58 | $18.26 | 9.1% | |
| 12 | $1.66 | $1.29 | $0.37 | $35.29 | $19.92 | 8.9% | |
| 13 | $1.66 | $1.31 | $0.35 | $33.98 | 8.4% | ||
| 14 | $1.66 | $1.32 | $0.34 | $32.66 | 8.2% | ||
| 15 | $1.66 | $1.33 | $0.33 | $31.33 | 7.9% | ||
| 16 | $1.66 | $1.35 | $0.31 | $29.98 | 7.4% | ||
| 17 | $1.66 | $1.36 | $0.30 | $28.62 | 7.2% | ||
| 18 | $1.66 | $1.37 | $0.29 | $27.25 | 7.0% | ||
| 19 | $1.66 | $1.39 | $0.27 | $25.86 | 6.5% | ||
| 20 | $1.66 | $1.40 | $0.26 | $24.46 | 6.2% | ||
| 21 | $1.66 | $1.42 | $0.24 | $23.04 | 5.8% | ||
| 22 | $1.66 | $1.43 | $0.23 | $21.61 | 5.5% | ||
| 23 | $1.66 | $1.44 | $0.22 | $20.17 | 5.3% | ||
| 24 | $1.66 | $1.46 | $0.20 | $18.71 | 4.8% | ||
| 25 | $1.66 | $1.47 | $0.19 | $17.24 | 4.6% | ||
| 26 | $1.66 | $1.49 | $0.17 | $15.75 | 4.1% | ||
| 27 | $1.66 | $1.50 | $0.16 | $14.25 | 3.8% | ||
| 28 | $1.66 | $1.52 | $0.14 | $12.73 | 3.4% | ||
| 29 | $1.66 | $1.53 | $0.13 | $11.20 | 3.1% | ||
| 30 | $1.66 | $1.55 | $0.11 | $9.65 | 2.6% | ||
| 31 | $1.66 | $1.56 | $0.10 | $8.09 | 2.4% | ||
| 32 | $1.66 | $1.58 | $0.08 | $6.51 | 1.9% | ||
| 33 | $1.66 | $1.60 | $0.06 | $4.91 | 1.4% | ||
| 34 | $1.66 | $1.61 | $0.05 | $3.30 | 1.2% | ||
| 35 | $1.66 | $1.63 | $0.03 | $1.67 | 0.7% | ||
| 36 | $1.66 | $1.64 | $0.02 | $0.03 | 0.5% |
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.]
I think this introduces more confusion than it was meant to solve. This post might lead a Newb to think that LC and Prosper lie and do not pay the stated interest rate or that they should sell their notes at 12 months because their return has dropped to 8.9%. This hypothetical 12% note pays 12% on all outstanding principal.
If you do not reinvest those dividend payments they sit around in your account earning zilch.
If a newb can’t figure out this basic stuff, I believe they fall under the SEC’s designation of “unqualified investor.”
Lou
P.S. To better illustrate what the headline was trying to say, maybe you should have a column for “Cash in account earning 0% interest”
for month two- cash =$3.32 int=0 combined interest rate=11.8%
@Lou, You know I had the cash balance column in there originally but I took it out because it might confuse things. But you are dead right. I should have mentioned that the investor does always receive 12% on their principal balance. I am actually going to adjust the post to reflect that point. Thanks for pointing that out because I don’t think I made that clear.
Even though you already addressed it, I have to reiterate what Louis said in that it adds more confusion than it solves. A better post would’ve just addressed “don’t keep extra cash in your account” which I think you’ve already hit up a time or two. The outstanding principal is always earning the 12 or whatever percentage. During the whole post I was thinking “whoa, whoa, whoa,” and don’t know if the clarification helps being at the end. *shrugs*
~Shawn
Prosper lender “shawnw2”
I would go so far to say that idle cash is actually costing you money due to inflation. Its an important post reminding folks the need to keep their money active.
Jason
I agree with Shawn and Lou.
Ifpeople don’t understand that principal gets paid down and that you only earn interest on remaining principal then they maybe should be considered “unqualified investors”. I still dream of a less regulated day where lenders would be able to have more input into which loans get funded or stay unfunded. But if lenders don’t understand such basic things as this then surely a more regulated environment like we have now is needed.
As others have stated I think this fundamentally comes down to understanding what you are buying. You are not buying an equity; you are not “buying” a CD. You are purchasing a note. By owning that note you are entitled to a coupon of $1.66 every month for 36 months. You paid $50 for the right to that income stream.
The risk you took was possible delinquency or default on payment and interest rate risk.
I say interest rate risk because as we have seen recently from LC and P, they can and will reprice or regrade new loans on the platform at any time. When they do this they devalue or appreciate existing notes depending on the change that is made.
Now this only matters if you trade on Folio, but it does mater and is a risk.
@Shawn, Adding confusion was certainly not my intent but the headline and intro was designed to get noticed. I think this is a critical piece of the puzzle that many investors just don’t understand. I know I didn’t get it when I started investing.
@Bilgefisher, I didn’t even mention the inflation piece but you are dead right. There are so many investments losing money to inflation today and certainly keeping your p2p investments in cash earning 0% is one of them.
@Lendstats, Great to hear from you again Ken. We all come to investing with different levels of education and we were all unqualified investors at one stage. I know people who are happy to stay unqualified investors but would like a good return. I have recommended some of my friends like this to go with a Lending Club PRIME account because they take care of it all for you. The problem arises when people believe they are qualified investors but they are not. That is where most of the regulations stem from I think. If we were all sophisticated investors we would need very little regulation.
@Charlie, It sounds simple but for many investors who join Lending Club or Prosper they have never invested in a note before and don’t understand how it works. That is why I wrote this post. Hopefully, between the post and these comments new investors will learn something.
@Charlie. I agree wholeheartedly. I look at prosper as an income stream not value gain. The value gain allows for an improved income stream. When a note defaults I do not see a loss of $100, but a loss of $2/mo net income or $4 month gross income for 3 years. I quickly invest that money to keep that income stream flowing. Know the end goal. Is it income, capital, both? Knowing this is the key to investing in anything.
Jason
@Peter
And I thank you for doing the explaining and providing a place for us to post!
I think this post is more misleading newbies than it helps and suggest you delete it. The comments clarify it, but the article itself is not good advice.
Maybe a more appropriate blog post title would have been “What is an installment loan and how does it work?”
People can correct me if I’m wrong, but here is my take on the article:
I think this article is actually better geared towards those who use folio for investing. It is important for them to note that the interest is front-loaded so that very little principal is paid down at the beginning of the loan, but over the life of the loan you are getting paid less interest with each payment and more principal. So for someone buying a note on folio should account for the reduced interest rate (rather than the original interest rate) that they are actually receiving. Of course, we’ve also noticed that defaults decrease over the life of the loan. So while you will receive a lower interest rate, you will also experience a lower default rate.
re: “The problem arises when people believe they are qualified investors but they are not. That is where most of the regulations stem from I think.”
In my opinion the problem arises when people (qualified investors or not) lose money and then are upset that they lost money at all. After all, all investments should increase in value and no investor should ever lose money. Sorry for my cynical take on this…
@Jason, Good points. I think few investors give much thought to the purpose of their investments other than “get a good return”. Having an end game in mind can keep it in perspective.
@Charlie, You’re welcome.
@P2P-Banking, I admit it wasn’t my best work (note to self: never write and publish a post with a head cold) but I am going to leave it up.
@Lendstats, My original title was actually “Why it is Important to Reinvest Your Cash” but I felt that wasn’t very compelling. I think the title is still ok, I just should have stressed the point of the return staying constant based on the principal balance.
You don’t receive a lower interest rate on an older loan. You always earn 12% on your outstanding principle. It doesn’t matter if you buy on folio or on LC.
@Peter, that would have been a better title. You also could have explained the advantages of reinvesting. Once someone gets their initial investment invested, then they get 3 or 4% back every month. If a person reinvests that, since it is a relatively small sum, he can choose what he thinks are the best loans, either lowest risk or highest rate or a good combo of both. Once you reinvest for a while, that’s when you can really see your returns improve. I love reinvesting.
@Roy, the interest rate is never reduced, no matter the age. If you choose to not reinvest and you leave your funds sit idle in your account then you are damaging your overall return, but why would anyone choose to do that?
“Why it is Important to Reinvest Your Cash”
Would have been a good sub title.
It is not a bad article as it is pretty thought provoking.
Haha! Yep, you guys are correct. I’m not sure what I was thinking.
The keyword is amortization and the table in the article is called an amortization schedule. At the end of the day, as long as the borrower doesn’t pay off his/her loan early, it doesn’t matter. Whether it is the first payment or the last payment, the amount is still the same. However, it is something to keep in mind when you look at the principle and interest amounts when you log in or check your statements. If the borrower contemplates paying off the loan off early, they may be shocked to learn they still owe close to the original amount they borrowed (principle) despite having made payments for a few months. Toward the end of the loan term, the pay off amount becomes much less with each payment since most of the interest has already been paid and payments are mostly going toward the principle. For the lenders, we get most of our interest up front, so even if the borrower pays off the loan shortly after it is issued, you didn’t loan your money out for nothing. That is what I think we need to take away from this article.
Storm, you always get the same percentage of interest throughout the life of the loan. Yes, the dollar amounts you receive are larger at the beginning, but they will always be a fixed percentage of the outstanding principal. So, a 5 year $100 loan at 12% interest that has 12 months left (outstanding principal approximately $25) will have an interest payment of $0.25 for the next month. compare that to a new $25 loan with a 5 year term earning 12%. the interest that first month will be $0.25. Its the same percent of the outstanding principal. As long you reinvest those payments at 12% your money will be making 12% no matter whether you hold the $100 loan with 12 months to go or a brand new $25 loan. (ideal world)
so, since holding either loan pays the same percent interest, Do you hold on to the old $100 or do you sell and buy a new $25 loan?
Lou
@Lendstats, Point taken.
@Storm/@Lou, That is why I produced the table. You can see the same thing if you click on any of the older loans in your portfolio. But I will say this – the five year loans have a much higher interest component in each payment. If my example above were a 5 year loan then the first payment would have been $0.61 of principal and $0.50 of interest. For higher interest loans the interest can dwarf the principal payments in the early months.
Peter,
No matter the title, you got folks talking about reinvesting which I presume was the whole point of the article. Its nice to see the different takes on how that money is reinvested.
Jason
Thanks Jason. I do like to see debate on here and my goal with the title was to spark some of that. I just wish I had thought more deeply about the post before publishing it.