Sunday, September 30, 2012

Choosing Loans on P2P lending sites

Since I set forth in the realm of P2P lending, I read about how people choose notes, thought this through, and now I have something to share!

First, do not believe the ratings given by the P2P lending sites (from now onward,  I shorten it to sites to save some typing). Sure, they may use some sophisticated methods to determine the borrowers rating, and they may even have the incentive to be conservative, since they receive 1% of all transactions, i.e. the more a borrower pays over time, they more these sites make. But personally I would set my own standards since I sometimes do not agree with their models.

My current lending club filters are set as the following:

  • 0 delinquencies in the past 2 years.
    I don't want anyone who has been late or had a default recently. 
  • Max 2 delinquencies in the past 7 years.
    Same rationale, but since 7 years is a long period of time, I'd be more lenient. 
  • No public records in 10 years.
    I don't want anyone who had declared bankruptcy. 
  • Loan amount below 20k.
    Higher the amount, higher the risk. 
  • Loan term must be 36 months or shorter.
    Track records have shown that 60 months loans typically go bad much more frequently, exceeding their rate premium.
  • Must have a job, and must have had the job for more than 2 years.
    A steady income is essential for repaying their debt.
  • Debt to income ratio must be below 35%.
    Too much debt then the guy is in a shit hole. He will probably get overwhelmed soon. 
  • Loan purpose must be debt consolidation.
    This one is actually interesting. When I started out, I gave loans to people that want to start a business. But then I thought about it, more start-ups fail than succeed. And to justify the risk, the loan must be convertible, then one can reap profit if a start-up actually makes it. Plus, if someone is willing to take a debt consolidation, at least he does care about his credit history and does not want to make late payments. If in the future he ran out of money again, he might do another round of consolidation. 
Secondly, do not be too risk averse. Many people only buy notes that are rated A or higher. Well, that will cap your return. Sure, notes with lower ratings might have more defaults, but usually the rate premium more than makes up for that. You do get a higher expected variance on individual loans, but then if you diversify, statistically, you will always come out ahead if you invested on lower grade loans. In addition, higher grade loans often gets paid back early, which eats into your return since you have to wait another 10 days or so for your new loan to get reviewed and issued. Personally, I aim for a nominal rate of 16%.

Thirdly, do not invest more than 25 dollars on a single person unless you have more than 20k to invest in this P2P game. When you use lending club's tool, it will often assign investment amounts of more than 25 dollars to a certain loan in order to achieve the desired over interest rate you want, so be careful! The reason for this is that having more money per loan or per borrower, greatly reduces your ability to diversify, and is hugely detrimental to a successful investment. If you can not find enough loans to invest in, it's better to wait than investing multiples of 25 on a single loan. As for the 20k limit, it is there because once you hit 20k, you would have 800 notes each worth 25 dollars, and I think 800 is a large enough number that the chance of you being "unlucky" is very very slim, additionally, the time it takes to manage 800 notes is fairly substantial and you probably do not want to increase this number any further. 

Currently, I have about 7.6k invested in lending club, 600 invested in prosper. Prosper was more of an experiment I ran before I solidified my P2P lending strategy, it currently has a return of about 8.8%. I opened two accounts in lending club, one ordinary and one IRA. I did not follow my rules once in lending club and bought 2 notes on the secondary market that had the same borrower, of course since it is the secondary market, it is not that easy to filter on notes, now I am paying for the consequences: both of them are in grace period and I do think they are heading for default. They are only worth 40 dollars, but that is enough to wipe out most of my returns on the ordinary account that has a balance of 2.6k. Both accounts in lendingclub are currently showing between 16% and 17% returns. 

I will keep you updated on how my P2P lending experience.

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