P2P Lending Best Practices 2016 – An Investor’s Guide

P2P Lending Best Practices

When investing in p2p lending there are a few best practices that every investor should follow. These best practices should be applied to any investment on a marketplace lending platform, including Lending Club and Prosper. We first covered this topic in 2011 and while many of the best practices remain the same, there are new considerations as the industry has matured.

Diversification

Investors should start an account by investing in at least 100 notes, and preferably many more. In the case of Lending Club and Prosper this means an account size of $2,500 ($25 x 100 notes). We’ve covered diversification in depth and this remains the most important factor in having a successful p2p investing experience.

The reason for this boils down to one point which is that the more notes you invest in, the less impact one individual note default will have on your portfolio. Your investment strategy should always start with investing in as many notes as possible and as a general recommendation this should be your approach as your account grows unless you are unable to keep cash invested. We often find individuals that have had a negative experience with a platform lack this key best practice.

Accredited investors should also consider investing across many platforms since there are many more options available today. Many of these other lenders focus on other demographics, whether it is the sub-prime market with higher projected returns or the millennial demographic. Beyond consumer credit, there are now platforms that cover almost every lending vertical including  small business loans, real estate loans, student loan refinancing and many more.

Throughout the next few years we are likely to see more options for retail investors in the form of Regulation A+ deals such as the new Fundrise eREIT and 40-Act funds. These will increase opportunities for further diversification.

Understand P2P Lending Risks

As with any investment, you should understand the risks that are associated with investing. Marketplaces that exist today for retail investors allow individuals to invest in unsecured consumer credit. Rates paid by the borrowers typically fall below rates which they would pay on a credit card and are typically higher than a secured loan such as a car loan or a mortgage. A majority of the borrowers state credit card refinancing or debt consolidation as a loan purpose, but loan proceeds can be used for any reason.

As an investor you will undoubtedly have defaults, but your performing notes should make up for those that default leaving you with a positive return. There are many factors that could have a negative effect on your portfolio that every investor should understand. These include:

  1. Recession
  2. Unemployment
  3. Interest Rates
  4. Regulation
  5. Platform Bankruptcy

While the industry has not really weathered rising unemployment or a recession, there is a likelihood of a recession in the future. Like credit card defaults, there is a high correlation between unemployment and unsecured consumer credit.

Regarding other risks, we have seen a few developments in recent years. We’ve seen Lending Club raise interest rates for borrowers following the Fed move in late 2015. If Lending Club continues to raise interest rates to the borrower and thus pass the higher return on to the lender this may not be as big of a concern. However, interest rates have only slightly increased so the impact of rising interest rates still remains to be seen.

In regards to regulation risk and platform bankruptcy, these are less of a concern these days. Both Lending Club and Prosper are well established companies who combined are well over $20 billion of loans funded. Lending Club is now a public company and holds $1 billion in cash on their balance sheet. Additional regulation is on the horizon, but it isn’t likely that this industry will be regulated out of existence. More likely is that any impending regulation will be somewhat burdensome but able to be weathered easily by the major platforms.

Research

One of the most incredible things about the marketplace lending industry is the amount of transparency the companies provide. As a new investor you are going to need to answer many questions.

  • How much should I invest in p2p lending?
  • What is the purpose and time horizon of my investment?
  • Am I a conservative or more aggressive investor?
  • What type of loans and loan grades will I invest in?

There is a wealth of information on this site, on the Lend Academy Forum as well as third party sites to help you make the best decision in your situation. To get an idea of the loans you would like to invest in you can use NSR Platform. Click on the Analytics tab and view Back Testing for the platform you are investing in. You can view loan performance from Lending Club and Prosper across years and dozens of credit criteria. This can help you understand what historical returns have been given specific filter criteria.

As you watch your account performance, it is important to understand how returns are reported within your account. Returns initially will be stated much higher until your notes have seasoned around 18 months. This is because it takes around 3 months for a loan to be charged off. After your weighted age of portfolio reaches 18 months, most loan defaults have already occurred and stated returns are likely to be accurate. It is recommended to utilize Lending Club’s Adjusted Net Annualized Return or calculate returns using XIRR.

Automate Your Investment

Although you may initially hand select notes on a platform, you’ll eventually find that this is a time consuming endeavor, especially if you have a large account. To solve this manual process Lending Club offers its own free automated investing, formerly called Prime.  Prosper has a similar automation tool called Automated Quick Invest. While these tools provide basic functionality, some investors opt for a more powerful third party tool or opt to have their account managed by someone else entirely. The four major tools are listed below and I recommend researching each one to see which is the best fit for your situation.

Keep Funds Invested

When you first open your Lending Club or Prosper account it may take several days or even weeks to deploy your capital. However, as the borrowers begin to make payments you will see the principal and interest payments build up in your account. It’s important to continue to keep your investment working for you by reinvesting the payments. Cash drag can significantly impact returns in an account.

Conclusion

These best practices are meant to serve as a starting point for new investors to understand how to be a successful p2p lending investor. If you search on this site you will find more detailed information on several of these topics. If you have other insight on other best practices when investing in p2p lending let us know in the comments below.

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Mark
Mark
Feb. 7, 2016 1:23 pm

Do you have a recommendation for percent of investing portfolio to dedicate to P2P lending? I’ve been putting more of an emphasis into P2P lending lately but don’t know if I’m overexposing myself, or if it’s simply personal preference.

Thanks!

Ryan Lichtenwald
Ryan Lichtenwald
Feb. 8, 2016 8:44 am
Reply to  Mark

Hi Mark, while I can’t give specific investment advice, you may find this post from LendingMemo beneficial: https://www.lendingmemo.com/stocks-bonds-lending-club-prosper/

Mark
Mark
Feb. 8, 2016 8:28 pm

Thanks. That article was a big help.

JOe
JOe
Jul. 28, 2016 3:12 pm

Are Non-Accredited Investors play in the new P2P platforms? and if we can, How can we legally invest in Non-equity companies? Thank you!

Ryan Lichtenwald
Ryan Lichtenwald
Jul. 29, 2016 7:12 am
Reply to  JOe

Hi Joe,

The only companies that are open to non-accredited investors at this time are Lending Club, Prosper, Fundrise and GROUNDFLOOR.

James L.
James L.
Jan. 12, 2017 4:08 pm

I have read many posts from Lending Club investors that (even when sticking with A / B loans) are seeing increased defaults some saying returns are around 2% a year now.

What is you take? Is this new industry run it’s course already and is just another financial sector ready to fall off a cliff?

Ryan Lichtenwald
Ryan Lichtenwald
Jan. 12, 2017 4:10 pm
Reply to  James L.

Hi James, we will have part 2 of the below post out soon which will touch on recent return trends:

https://www.lendacademy.com/recap-recent-performance-trends-lending-club-prosper-part-1/

Igor K.
Feb. 27, 2018 12:24 am

P2P Lending is quite new in Indonesia, yet it has gained a lot of attentions from the community.
It’s best for people to know all about P2P lending and the best practices.