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How to Get Started with Peer to Peer Lending

by Peter Renton on February 16, 2011

Getting started with peer to peer lending can be a bit daunting for new investors. Lending Club and Prosper offer hundreds of loans to choose from and a myriad of ways for you to invest your money. Some people, eager to get started, jump out of the gate without thinking through their options and end up disappointed with their investment returns. The shrewd investor does some initial planning and research in order to get off to a great start. Here are a few points to consider to help you do just that.

Cherry Pick or Auto Plans

The first decision you need to make is whether you are going to invest in loans individually or go with one of the automated plans offered by Lending Club and Prosper.  If you have a large amount to invest ($10,000 or more) I recommend you consider starting with an automatic plan or you can look at Lending Club PRIME if you prefer a completely hands off approach. If you choose to invest in loans individually, and this is really the only way to obtain above average returns, then you need to pay close attention to the points below.

Diversify

If there was only one word of advice I could give to all new p2p investors it would be this one: diversify. Don’t make the mistake I made and spread your initial investment among two loans. What you want to do is diversify your initial investment as widely as possible. Both Lending Club and Prosper allow a $25 minimum investment in each loan. Take advantage of it. If you are starting off with $1,000 then fund 40 different loans with this money. Only if you are starting with more than $2,500 do I recommend you going over the $25 minimum. Then I would still make sure that no loan is more than 1% (and preferably less) of your total p2p investing portfolio.

Don’t Shoot for the Moon

You have a choice to invest in A grade loans that earn in the mid single digits in interest to loans of over 20%. Sure, you might think, a 20% return sounds much better. But keep in mind these are higher risk borrowers that historically have had a higher default rate. So a portfolio of loans that are earning over 20% could easily end up with a real world return under 10% once all the defaults have been taken into consideration. Whatever your risk tolerance, for new investors I recommend a broad portfolio with a range of different loan grades. Having said that I tend to avoid A grade loans, I think they are risky for a different reason. We are in a historically very low interest rate environment right now and it is highly likely that in two or three years interest rates will be much higher than they are now. If you can get 6% in an FDIC insured CD, it makes 7% in a p2p lending investment a poor choice. I like to invest in loan grades of B and below.

Use Some Simple Filters

So you have transferred your money in and have decided you want to invest in individual loans. So you login to your Lending Club or Prosper account and start browsing through the dozens or even hundreds of loans. You suddenly realize you are going to be here all day unless you can narrow down your selections somehow. This is where filtering comes in. Both Prosper and Lending Club allow you to filter loan selections on their site. Prosper’s filtering is much better than Lending Club, so what I do for Lending Club is download the CSV file of all available loans (In Funding Loan Data) and filter them in Excel.

You can spend hours (or in my case, days) playing around with filtering on a p2p lending statistics site like Lendstats.com (they have separate Lending Club loan filters and Prosper loan filters). You can slice and dice previous loan ROI data in many different ways, but there is one filter I recommend for everybody: Inquiries = 0. Inquiries means number of credit inquiries this person has undertaken in the last six months, it is recorded on a borrower’s credit report. I like to invest in someone who has not been shopping around in many places for more credit. I use other filters but this one seems to have the biggest impact on ROI based on previous loans. Of course, we need to state here that past performance is no guarantee of future returns. This filter may not produce superior returns in the future, but for past loans for both Prosper and Lending Club if you had chosen that filter and nothing else you would have increased your ROI considerably.

Read the Details of Each Loan

I think it is useful to spend some time reading the details of each loan. If nothing else this will give you a feel for the different kinds of borrowers on the platform. I tend to avoid someone who hasn’t bothered to give a good loan description (or any description) and if they have failed to answer investor questions then that is a red flag, too. You can always ask your own questions, keeping in mind of course, that people may not always tell the complete truth.

Start Slowly

As a new investor you are probably all excited to get started and want to get all your money to work quickly. But if you have done the work of the other steps above you will likely only have a relatively small number of loans to choose from. For example, you might have $2,000 to invest and have narrowed your search down to 40 loans to invest in. So, you think you should just invest $50 in each loan. That is not what I would recommend. Stick with my diversification point above and stay with $25 per loan. Invest half your money now and then wait a week or two. There will be an entire new batch of loans on the platform then, and you can repeat the process. I know some investors who have repeated this process many times before all their money was invested.

Avoid Taxes if You Can

Interest earned on your investments at Lending Club and Prosper are taxed at the standard income tax rate, they do not get the favorable tax treatment of stock dividends. So, if you are in the 28% federal tax bracket then you will likely pay 28% in federal taxes on all of your interest income earned from p2p lending. You can avoid this tax burden completely by putting your investment in an IRA. Currently, Lending Club offers a no-fee IRA where all your interest can accrue tax free. You can open a Roth IRA or a traditional IRA and invest $5,000 per year (for people over 50 that number is $6,000 per year).

So, those are the points I consider most important when getting started in p2p lending. New investors are coming on board every day at Lending Club and Prosper looking for the superior returns that can be obtained with peer to peer lending. While it certainly offers the potential of consistent double digit returns for shrewd investors, most investors are in fact earning less than 10%. Follow these steps above and you will likely be ahead of the vast majority of investors.

Now, I would like to open it up to others. These thoughts are just my opinions and observations gathered after almost two years as an investor. I know there are many long time peer to peer investors who read this blog, plenty with more experience than me. What else would you say to the newbie investor? Please provide your feedback below. Thank you.

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Matt SF February 16, 2011 at 2:05 pm

Good stuff Peter. I started out very slowly, and in some respects, I still am by only adding $500/month, but considering the present day economic environment (e.g. most people scared stiff to invest in anything) and that P2P lending is still a relatively nascent industry, a little caution seems like the prudent thing to do for a novice investor.

Like you, for new investors, I’d recommend maybe a few $100 to begin with, no more than $25/note and not try to swing for the fences in terms of return on investment.

Mike February 16, 2011 at 3:08 pm

I would suggest keeping ALL of your loans at the $25 level. You will appreciate this advice once the defaults start coming in, and they will no matter how carefully you screen the listings. I would also suggest selling any loan that goes into the grace period, or at the very least, goes into late status. Even if you take a minor loss, it’ll be better for your ROI than having it written off. As far as limiting your loans to those without any credit inquiries, that may eliminate many people who went to their local bank to see what rate they could obtain before checking out Lending Club or Prosper. Two or more inquiries would raise a red flag for me, however. I never invest in anybody that has had a previous bankruptcy, and I never invest in people needing to pay off medical costs. (This is the number one cause of bankruptcy in this country.) Verified income is always nice, but isn’t very common on the Lending Club platform. If there any spelling or grammatical errors, out it goes. Answers to questions must be well thought out, logical and timely. Someone who waits four days to answer a question isn’t getting any of my money. Just my .02, so to speak.

Peter Renton February 16, 2011 at 3:58 pm

@Matt, Thanks for your comment. I agree that every p2p lender could be better served by taking a slow and cautious approach.

@Mike, You make some good points, here. I didn’t mention the trading platform, but it is something that all p2p investors should check out once they have their money invested. A small loss is better than a total loss, even on a $25 loan. Because, as you point out, every investor will have defaults sooner or later.
I know with the Inquires = 0 filter I will miss out on many great loans. But when I run the ROI numbers, there is a big difference between Inquiries = 0 and Inquiries = 1 or 2.

Investor Junkie February 16, 2011 at 5:36 pm

At least for me the one thing I would recommend is still doing it slowly. For me with my standards, it’s hard to find a lot of loans that meet my qualifications. As Matt SF mentioned, I think I could only max out at around $500/mo. This should change as more people use services like Lending Club.

In addition, unlike other investments your money is somewhat illiquid. So do make sure you are investing either for the full term of the loans or close to it.

KenL February 16, 2011 at 6:20 pm

Hi Peter,
I agree that 0 inquiries is a great way for newbies to start. It eliminates a lot of risk and still leaves a lot of loans to choose from. Another recommendation I have for newbies is to stay away from business loans. If all newbies used those 2 criteria for the first 100 notes negative returns would be nearly extinct.

At lendstats.com I have a 0 inquiry filter as you mention. It also filters for some other basic criteria and using that filter there are well over 100 current listings to choose from, which is plenty for a newbie to learn the ropes. Here’s a link to the filter page http://www.lendstats.com/loansearch/lc/lcloanfilter.php

Peter Renton February 16, 2011 at 8:42 pm

@I-J, Good point on the illiquid part, I should have mentioned that. If you invest in 5 year loans then will only get a bit over 20% of your money back a year. New investors should be wary of that.

@Ken, Staying away from business loans is another good tip. While, I do invest in business loans, they tend to underperform the average and so it is probably good advice for newbies to avoid them.

Thanks for your comments, gentlemen.

Mike February 19, 2011 at 3:24 pm

Regarding the liquidity of your investment, don’t forget about the trading platform linked to the Lending Club site, and maintained by folio. I’ve had good success selling notes there.

Peter Renton February 19, 2011 at 4:33 pm

Mike,

Yes, the trading platform is something that all investors should check out once they have learned the ropes. Both Lending Club and Prosper offer a secondary market for buying and selling notes. Here is a link for more information:
Lending Club: http://www.lendingclub.com/public/mainAboutTrading.action
Prosper: http://www.prosper.com/invest/trade.aspx

Thanks for your comment.

Scott February 23, 2011 at 11:14 am

How quickly should I expect the payments to hit my account? I have two loans that were due on 02/17/2011 but I haven’t received payment yet. I’m starting to get worried!

Peter Renton February 23, 2011 at 12:27 pm

Scott, Good question. It usually takes 5 or 6 days for a payment to post to your account. I just went into my account and checked some of my loans that are more than 18 months old and that have paid on time every month. I have a bunch of these notes with payments due on 2/16 and 2/17 that haven’t posted this month’s payment yet. So I wouldn’t worry. I would expect that by Friday you should see the payment in your account. If you haven’t seen payment in your account by the weekend, then it is most likely these loans will be entering “In Grace Period”.

Nichele July 24, 2011 at 4:34 pm

I stumbled across p2p lending on the Internet while browsing for something totally not money or investment related. I had heard of charitable/non-profit p2p lending with poor countries trying to start businesses, but not anything like Lending Club or Prosper.
I am by no means rich, or even “well-off”, but I am interested in this idea. My banks’ savings is 0.30% & 1.00% APR, which is dismal. I have about $1000 that I can begin investing, but am still extremely hesitant. I’ve read several of the posts on a few links. They have made me at least as hesitant as I am interested. There’s a person who posts almost entirely in doubt and negativity. Of course, this is an investment opportunity and will certainly not be all peaches and cream, but gee whiz! Anyway, I am still not certain exactly how to “start”. This is interesting, but scary. Any positive (and constructive) advice is much appreciated.

Peter Renton July 25, 2011 at 9:24 am

@Nichele, You are joining tens of thousands of other investors by giving p2p lending a go. The first thing I would do is get my free ebook, Understanding Peer to Peer Lending. You can read the whole thing in 15 minutes and it will give you a basic understanding of everything (you can subscribe by just entering your email address under the ebook graphic in the top right of this page).

Then I would start investing with whatever amount you are comfortable with. Make sure you invest only $25 per note and decide what loan grades make the most sense for you. Let me know if you have any more questions.

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