P2P Lending: Peer-to-Peer Lending and Investing in Unsecured Notes

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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.

Related: BP Podcast 028: Note Investing and Raising Private Money with Dave Van Horn

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.

Related: BP Podcast 029: Using Peer-to-Peer Lending to Finance Deals, Cash Flow, and Fix and Hold Investing with Dawn Anastasi

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.

Happy investing!

*https://www.lendingclub.com/public/how-we-set-interest-rates.action

** http://blog.lendingclub.com/2008/10/14/lending-club-sec-registration/

Photo: Alex E. Proimos

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

17 Comments

  1. Matt Devincenzo on

    Great article Dave. I used Prosper a couple years ago right around when they started allowing/supporting IRA’s, though I only ever invested my personal dollars. For myself my returns were ok, but I got several bad loans that defaulted and negatively impacted that return. I have a couple rentals in my IRA currently and will likely cash those out in the next couple years, so while I continue to receive rent and contribute every year I’ll get to the ability to buy RE backed notes at some point

    Now as I’m looking to invest my smaller IRA uninvested cash into notes (10-15K) I’m not quite where I can purchase discounted RE backed notes, and any I could would be “putting all my eggs in one basket” since I would only be able to get 1 note at that price. A question for you is what criteria do you find in P2P notes that produce the better return that I could invest my IRA in so that cash is still working while I continue to build it up to be able to invest in RE backed notes later.

    • Dave Van Horn

      Matt,

      Appreciate the feedback!

      I’ve listed multiple funds and companies that sell Peforming and Non-performing notes in the past on the website, but feel free to message me if you need more info.

      As far as my Lending Club criteria goes, I do a little bit of everything. To spread my risk around, I invest in multiple different categories but my investment depends a lot on the default rate of the category. For example, I’ll invest more money in notes in the safest category (with a a default rate of less than 2%) as opposed to the riskier categories which still invest in, just not as much. I also like the 5 year loans and loans that are seasoned a bit so I know they’re more likely to continue paying. I’ve also had some success with wedding loans and Green energy related loans because they typically seem to have a lower default rate. But again, this is just my opinion, but I’ve tried to use some statistical analysis from my note business into how I purchase LC loans. The reason I mentioned Interest Radar was because that site really gives a lot of tips and helps you create a strategy that fits your risk tolerance and the amount of money you’re willing to invest.

      Hope this answer helps,
      Dave

  2. I personally saw that rates on Lending Club, as a borrower, were lower than what could be had at Prosper. The only downside I found to the Lending Club situation is that I was only able to borrow up to 2 loans at $35,000 each. It would have been nice to have 3 out at one time. Or for more responsible borrowers, even more than that. I’ve since paid off both loans I took out in full, so I do have the option of taking out more loans again if I need them.

  3. I checked into this a few months ago. As I understand it, folks in Texas are not eligible to participate as note buyers. I thought it was an interesting way to diversify some assets. I wish it was available for me.

    • Jason,

      I have a similar issue as an investor in Pennsylvania, but Lending Club works with a company called Folio Investing that allows you to invest from anywhere in the country. If you’re in a state like Texas, essentially you’ll investing in Lending Club through Folio in and Folio takes a really really low percentage fee. I would call Lending Club if you had any more questions about it, they explained the whole process to me when I first started investing.

      So for the time being there are different rules for different states but after talking to a representative at Lending Club, I was told that once they go public it will be the same rules applied nationwide. I’ve heard that’s going to be sooner rather than later, they’re expected to do over 3 billion dollars in revenue this year and Google just invested a large sum of money in the company so that’s a really good sign!

      Best
      Dave

  4. This was a timely article for me as I had opened Lending Club and Prosper accounts months before but am just now getting ready to try my hand at it. Dawn’s podcast and now your article pushed me over the fence to transfer some minimal funds and give it a whirl.

    It’s great to hear executives from traditional banks are getting on board too.

    And thanks so much for posting the info on Interest Radar – I’ll be sure to check that out!

  5. Dave, I had a question that popped up after I received your letter telling me about investing in PPR and how I could use my IRA to invest in that.

    Is it possible to use money from an IRA or retirement account to invest in peer to peer?

    • Hi Mark, it depends which state you’re in. (have to check with Lending Club) Last time I checked it was allowed in 26 states & of course my state of PA wasn’t one of them. If they do go public though you’ll be able to invest from your IRA from all 50 states.

  6. Wonderful! I’ve been looking for a way to get started in note investing when capital is at a minimum. If I can put $25 dollars in every so often it will be a great way to understand the basic processes and build my confidence in understanding the strategy. At which point I can put more and more into the program.

    • Hi Steve, it’s a great way to get started in investing. Even though its unsecured, they do report to credit, so this provides incentive to pay. They’re overall default rate is pretty low. I still use Lending Club, as a hobby / part of my portfolio. Good luck!
      Dave

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