I started investing in peer to peer lending three years ago and immediately jumped into the research. I went through hundreds of simulations using online backtesting sites to determine what my investment strategy would be. Once I had a strategy, I used an auto investment process to invest in notes as they become available. But now, I’m getting out.
Basics of Peer to Peer Lending
Peer to peer lending or P2P lending enables investors to loan individuals money in whole or part of the requested amount. P2P marketplaces allow borrowers an alternative to traditional financing options like banks. There is little underwriting, so the loans come with a lot of risks. Despite the risks, investors fully fund many of the loans before the P2P marketplace confirms any of the borrower information.
Investors can invest as little as $25 in a loan which makes diversification easy. Thankfully there are filters and auto investment processes to help investors sort through thousands of business loans, credit card consolidations, and requests to finance a dream car. I’ve only had experience with the lender side of P2P lending, so I can’t speak to the borrower process.
Why I’m Bailing
The process is exciting, and I love the opportunity to diversify out of the standard allocation to stocks and bonds.
I ran a portfolio IRR and came to a sad conclusion of 5.9%. Rough.
While low, the investment isn’t finished since loans are on 3-5 year terms. LendingRobot, the company I use for auto investing, shows an expected return for this year of 17.45% so only time will tell. I’ll be sure to provide an update as time goes on.
The loan selection criteria I used focused on high-risk debt with interest rates breaching 30%, so expected returns and default rates are difficult to estimate. Because of the individual loan risk, I have diversified through hundreds of these loans in my portfolio. With this many loans, unwinding will take some time.
The truth is the return is not the main reason I am exiting the P2P lending game. The loan length of 3-5 years means that my money is tied up for longer than I’d like. In addition to the capital lockup, I want to do some further default prediction analysis before I continue to invest. I’m uneasy investing in something when I don’t have all the information.
The Exit Strategy
As these individual loans unwind, I have stopped the reinvestment process. Now I am letting the principal and interest payments sit in cash as I set up the distribution to another IRA.
Unwinding will take some time before I am entirely divested of the P2P positions. The timing worked out well since I invested the bulk of my account three years ago meaning that a lot of loans have come due in the past quarter and will continue in the current quarter.
I want to continue the diversification purpose of this stack of cash, so I’m looking at alternative areas. Real estate is the top choice, but I don’t want to become a landlord or hold personal notes since that is difficult to diversify. Remaining options include real estate crowdfunding like Realty Shares or the classic REIT.
The P2P lending space is an exciting one. It offers a unique diversification opportunity, but for me, I didn’t have the time to properly research and develop a strategy and process that didn’t rely on someone else’s assumptions.
I’d have no problem going back to P2P lending and at some point, I likely will. However, before I dive back in, I plan on digging into the data myself to estimate a proxy for default risk. Luckily LendingClub makes past loan data available, so it’s there when I’m ready to reopen those doors.
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I’m divesting myself of my p2p accounts because they are making very little money–and the economy is good. If things go south, those loans are going bad even more. As long as “normal” in a good economy was 8%, investors could afford a year or two at 0-2% but when a good year economically gives you sub-5% earnings, there just isn’t much room to go down.
One risk I didn’t think about when I started to invest was the risk that the platforms would change their loan underwriting criteria. You talk about all the backtesting you did–and I did the same thing–but it only works if the lending critieria and interest rates remain stable. If the class of borrowers who were paying 15% two years ago are only paying 5% now, then backtesting is pretty useless.
Great explanation. The loan underwriting is a major issue and the lack of consistency in the process makes it difficult to backtest anything.