Getting started with peer to peer lending can be a bit daunting for new investors. Lending Club and Prosper offer hundreds of loans to choose from and a myriad of ways for you to invest your money. Some people, eager to get started, jump out of the gate without thinking through their options and end up disappointed with their investment returns. The shrewd investor does some initial planning and research in order to get off to a great start. Here are a few points to consider to help you do just that.
Cherry Pick or Auto Plans
The first decision you need to make is whether you are going to invest in loans individually or go with one of the automated plans offered by Lending Club and Prosper. If you have a large amount to invest ($10,000 or more) I recommend you consider starting with an automatic plan or you can look at Lending Club PRIME if you prefer a completely hands off approach. If you choose to invest in loans individually, and this is really the only way to obtain above average returns, then you need to pay close attention to the points below.
If there was only one word of advice I could give to all new p2p investors it would be this one: diversify. Don’t make the mistake I made and spread your initial investment among two loans. What you want to do is diversify your initial investment as widely as possible. Both Lending Club and Prosper allow a $25 minimum investment in each loan. Take advantage of it. If you are starting off with $1,000 then fund 40 different loans with this money. Only if you are starting with more than $2,500 do I recommend you going over the $25 minimum. Then I would still make sure that no loan is more than 1% (and preferably less) of your total p2p investing portfolio.
Don’t Shoot for the Moon
You have a choice to invest in A grade loans that earn in the mid single digits in interest to loans of over 20%. Sure, you might think, a 20% return sounds much better. But keep in mind these are higher risk borrowers that historically have had a higher default rate. So a portfolio of loans that are earning over 20% could easily end up with a real world return under 10% once all the defaults have been taken into consideration. Whatever your risk tolerance, for new investors I recommend a broad portfolio with a range of different loan grades. Having said that I tend to avoid A grade loans, I think they are risky for a different reason. We are in a historically very low interest rate environment right now and it is highly likely that in two or three years interest rates will be much higher than they are now. If you can get 6% in an FDIC insured CD, it makes 7% in a p2p lending investment a poor choice. I like to invest in loan grades of B and below.
Use Some Simple Filters
So you have transferred your money in and have decided you want to invest in individual loans. So you login to your Lending Club or Prosper account and start browsing through the dozens or even hundreds of loans. You suddenly realize you are going to be here all day unless you can narrow down your selections somehow. This is where filtering comes in. Both Prosper and Lending Club allow you to filter loan selections on their site. Prosper’s filtering is much better than Lending Club, so what I do for Lending Club is download the CSV file of all available loans (In Funding Loan Data) and filter them in Excel.
You can spend hours (or in my case, days) playing around with filtering on a p2p lending statistics site like Lendstats.com (they have separate Lending Club loan filters and Prosper loan filters). You can slice and dice previous loan ROI data in many different ways, but there is one filter I recommend for everybody: Inquiries = 0. Inquiries means number of credit inquiries this person has undertaken in the last six months, it is recorded on a borrower’s credit report. I like to invest in someone who has not been shopping around in many places for more credit. I use other filters but this one seems to have the biggest impact on ROI based on previous loans. Of course, we need to state here that past performance is no guarantee of future returns. This filter may not produce superior returns in the future, but for past loans for both Prosper and Lending Club if you had chosen that filter and nothing else you would have increased your ROI considerably.
Read the Details of Each Loan
I think it is useful to spend some time reading the details of each loan. If nothing else this will give you a feel for the different kinds of borrowers on the platform. I tend to avoid someone who hasn’t bothered to give a good loan description (or any description) and if they have failed to answer investor questions then that is a red flag, too. You can always ask your own questions, keeping in mind of course, that people may not always tell the complete truth.
As a new investor you are probably all excited to get started and want to get all your money to work quickly. But if you have done the work of the other steps above you will likely only have a relatively small number of loans to choose from. For example, you might have $2,000 to invest and have narrowed your search down to 40 loans to invest in. So, you think you should just invest $50 in each loan. That is not what I would recommend. Stick with my diversification point above and stay with $25 per loan. Invest half your money now and then wait a week or two. There will be an entire new batch of loans on the platform then, and you can repeat the process. I know some investors who have repeated this process many times before all their money was invested.
Avoid Taxes if You Can
Interest earned on your investments at Lending Club and Prosper are taxed at the standard income tax rate, they do not get the favorable tax treatment of stock dividends. So, if you are in the 28% federal tax bracket then you will likely pay 28% in federal taxes on all of your interest income earned from p2p lending. You can avoid this tax burden completely by putting your investment in an IRA. Currently, Lending Club offers a no-fee IRA where all your interest can accrue tax free. You can open a Roth IRA or a traditional IRA and invest $5,000 per year (for people over 50 that number is $6,000 per year).
So, those are the points I consider most important when getting started in p2p lending. New investors are coming on board every day at Lending Club and Prosper looking for the superior returns that can be obtained with peer to peer lending. While it certainly offers the potential of consistent double digit returns for shrewd investors, most investors are in fact earning less than 10%. Follow these steps above and you will likely be ahead of the vast majority of investors.
Now, I would like to open it up to others. These thoughts are just my opinions and observations gathered after almost two years as an investor. I know there are many long time peer to peer investors who read this blog, plenty with more experience than me. What else would you say to the newbie investor? Please provide your feedback below. Thank you.