How Prosper is Providing a Portion of my Early Retirement
Peer to peer lending (P2P) has been a trending investment topic for a few years now. I think there are still a lot of people that are either on the sidelines because they have never looked into it or think it is too risky. Risk tolerance is a personal decision and while it may change over time, if P2P lending is not for you now it probably won’t ever be for you. For those that might want to know more or just need to see someone else’s experience to move forward, this article just might be for you.
First off, why use P2P lending as part of an early retirement strategy? Well, let me answer that with asset allocation is the reason. If you use Personal Capital then you would see it has a group called Alternative assets. Prosper fills that role for me. While I am sure there is some correlation between loan defaults and a bad economy with a bear market, I am not directly invested in the stock market or real estate with these funds. Using this account lets me invest funds that have a predictable cash flow with predictable default rates (based on calculations from the lending sites based on real data). While the return is obviously not guaranteed, you can see the expected range of results for different risk levels. I should also add that I have been on Prosper for over 8 years (since 2006).
There are two major P2P sites out there Lending Club and Prosper for those in the US. While there are differences, the major premise is the same. Individual investors loan small amounts and collectively fund a loan for an individual. This is why it’s sometimes called micro lending; you are only providing a small portion of each loan. Because of the size of the loans, you can diversify your risk by making hundreds of loans. For example, on Prosper if you had $500 you could make 20 loans @ $25 each. It is important to make a lot of loans otherwise a default has a larger impact. One default in 10 $100 loans has a lot bigger impact than a default in a pool of 40 $25 loans. Since $25 is the minimum, I try to keep my loans at $50. I have gone over that once or twice in the past for lower risk loans, but no longer break that rule.
After you decided what size of loans, you have to consider the borrowers. Many people come up with elaborate strategies on what types of borrowers to choose from. You can evaluate on many areas such as credit score, recent credit inquiries, defaults, current revolving balances, home ownership, income, time in job, etc. Basically, the choice comes down to what your risk tolerance is. If you want to shoot for a high return, you will have to loan to borrowers with serious mistakes in their credit usage.
Once the loans are funded, it’s really on autopilot. You do not have to collect the payments; they just come into your account. You can even set it up to push to your main bank account on a regular basis if you like. Collection activities for loans in default are also automatic with no action needed on your part. You did all your work on the front end selecting the loans to make, after that you just get the cash!
My personal filter is set something like this:
- Look for stated income of at least $40k and 2+ years status
- No current delinquencies
- No more than 1 delinquency in the last 7 years
- Bankcard utilization not over the loan amount, but look for under $10k
- Home Ownership: yes
- First credit line at least 10 years ago (limits youngest borrowers)
- No more than $20,000 loan amount (usually try for $15,000 or less)
- Try for 3 years vs 5, but only a preference
- Most of my loans end up being A and B, with some AA and a few C.
This set of filters and investment style has me earning a 9.79% return for 2013-2014. I have had way more loans pay off early (8), than I have had go into default (1) in that time period. This is based on making 70 loans in that time, most of which were in 2013. On a roughly $3,400 investment I have made about $440 in interest ($263 in 2013 and $177 in 2014 through July). If that money was sitting in my .50% online savings account it would have earned about $35 by the end of this year. Obviously P2P lending is not a good spot for your emergency fund, but it might be a good spot for some extra cash that comes in and you don’t want to put more funds into the stock market right now.
While the cash is locked up for the most part (you can sell loans, but I have not tried that) you do get a fairly predictable monthly cash flow once all the loans are in place. I was taking out the cash (about a 5 day lag form request to it being back in your checking account) for a long time, but have started funding 1-2 more loans per month now. I have seen others document a higher return, but I like my low default rate and feel more comfortable getting 8-12% interest from borrowers. Much higher than that and I feel like I am being greedy like the big banks! Regardless of your risk preference, peer to peer lending has a legitimate place in your portfolio. Much like real estate and commodities, it can diversify your portfolio away from just the stock and bond markets.
Do you have any experience with P2P lending?