In 2005, I was first introduced to the world of unsecured notes and mortgages. At the time there probably wasn’t anything on my investing options radar that had to do with utilizing “Unsecured Notes” as an investment vehicle. You see, I had just been introduced to the world of investing in delinquent mortgages, primarily second mortgages, and occasionally some of these eventually became unsecured – like after the 1st mortgage foreclosures or the 2nd lien is stripped through a bankruptcy. What was amazing to me was that people invest in unsecured debt until I started to realize collection attorneys like this stuff and they prefer to chase ‘the person’ as opposed to chasing ‘the property’ (like a foreclosure attorney would). But I wasn’t a collection attorney, so why would I care about unsecured?
So, a few years later a friend of mine, who owns a self-directed IRA a company, told me about a cool way to invest through my IRA account in ‘unsecured notes’. He asked me to check out LendingClub.com(BiggerPockets Partner Link). I looked into it, but of course I did not do anything since I was investing most of my extra capital in re-performing mortgages, where I felt I had a safer investment because these notes had collateral since they’re liens secured by property. The only problem was these secured loans required much more cash to purchase than unsecured notes, but of course I still didn’t think differently yet.
Then a few MORE years past and I was having lunch with my staff and a student/note buyer of mine and he started telling me about the success he was having with Lending Club and how he was averaging over 15% returns and higher. So then I started to pay attention and get involved, and today my staff and I are investors in Lending Club and we love it! It’s an excellent way to start out in the note business, especially since you can diversify your risk through several small increments ($25 minimum) invested in many different loans or borrowers.
So What Does P2P Mean and How Does it Work?
So, what exactly is Lending Club, or Peer-to-Peer Lending,” P2P“, also known as Person-to-Person Lending, Peer-to-Peer Investing and Social Lending? It’s defined as the practice of lending money to unrelated individuals, or “peers”, without going through traditional financial intermediary such as a traditional bank or other financial institution. This type of lending takes place online on peer-to-peer lending companies’ websites using various different lending platforms and credit checking tools.
Most peer-to-peer loans are ‘unsecured personal loans’, that are made to individuals and borrowers that do not have to put up a collateral. Today, you even see ‘business loans’ that are available on P2P sites as well.
On Lending Club, interest rates are fixed by the company based primarily on the borrower’s credit – with all borrowers being required to have a FICO score of 660 or higher*. Borrowers that are assessed as ‘higher risk’ are assigned higher rates. Although there is no government protection for investments made by lenders in a loan, lenders can mitigate their risk by choosing which borrowers and types of loans to invest in and by diversifying their investments among many different borrowers. Every fellow Lending Club investor I meet has a different and interesting investing strategy. For example, my friend chooses to play it safe by ONLY investing $25 increments in multiple different categories of notes to mitigate his risk. I on the other hand, prefer to invest larger increments but in the safest category of loans, going for a steadier return. What’s interesting is, we both usually focus on similar minimum FICO scores and borrower history info when looking for loans to buy.
After 2008, these types of lending companies fell under the oversight of the SEC, (Securities and Exchange Commission). Websites like Lending Club.com (BiggerPockets Partner Link) and Prosper.com not only have gained full approval of the SEC but have also partnered with FOLIO Investing to create a secondary market for their notes by providing an online trading platform, thus allowing liquidity to investors**. This combined with the transparency of gaining access to detailed information on each individual loan without knowing the borrower’s identities prior to participating in the funding of each loan is what finally won me over to this model.
At first, I had been stuck on the fact that these loans were unsecured, but once I realized the overall default rates of Lending Club loans, as well as the fact I can invest small amounts with many different borrowers my reluctance subsided. Since inception, Lending Club’s default rate ranges from 1.4% for the top rated, three-year loans, to 9.8% for the riskiest categories. After all, even credit card debt is ‘unsecured’, but look how much of that is available through traditional banks. Both are reported to credit agencies and have variable rates and terms available, based on a borrowers’ risk.
So What’s In It For Them?
P2P lending platforms are for profit, online businesses that generate their revenue by collecting a onetime fee from borrowers on funded loans, and/or by assessing loan servicing fees to investors, either by a fixed amount annually or a percentage of the loan amount. Since these services are so automated, these companies can operate with much lower overhead than traditional financial institutions and can pass this on to borrowers with much lower rates. Thus, simultaneously allowing lenders to earn higher rates.
Since June 2012, Lending Club has been the largest peer-to-peer lender in the United States, and the world, with over $1.5 billion in loans. They’ve had over 100% per year growth and P2P is one of the fastest-growing investments. Even executives from traditional financial institutions are joining the P2P companies as board members, lenders, and investors indicating that the new financial model is establishing itself in the mainstream.
My overall take is that if it’s good enough for traditional banks it’s good enough for me. I’ve even gone so far as to utilize a site called Interest Radar, (reminds me of my old days of trading options), where serious P2P investors can use their statistical tools to preset more aggressive strategies that can range from over 15% to 20% return rates (including your net of loss rates). Interest Radar will also help you keep track of the notes you invested in from the moment you selected the loan until it’s paid off, not to mention they feature tools for automated buying techniques and stop-losses. So, if you’re thinking of getting started in notes but only want to use a small amount of capital, then I strongly suggest you check out LendingClub.com, FOLIO.net, and InterestRadar.com.
Photo: Alex E. Proimos