Recently I have decided to diversify my investments by opening an account with Lending Club where I’m currently getting over a 13% return on my investments.
I live in Texas so I’m not legally allowed to originate loans. The only way I can use Lending Club is to buy loans that other people don’t want. This is obviously frustrating and I’ll be contacting my congressmen to try to get the law changed, but there is a silver lining in every raincloud.
I actually think buying other people’s loans is better than originating them myself.
Existing Loans Have a Payment History
When you originate a loan, you give $20 to a complete stranger based on his credit score, a few financial stats, and a few paragraphs about his plans for the money. That sounds scary to me.
When you buy an existing loan, you get one more vital piece of information: payment history.
When I’m looking for a safe place to invest my money, I filter the loans on “Never Late” and remaining payments of 30 at most. All loans have either a 36 or 60 month term, which means this filter will show loans where the borrower has made at least six payments on time.
Six or more on time payments gives me good reason to believe that person is going to keep making payments. Sure, you have to pay a markup of about 1-3% (meaning you’d pay $20.60 for a $20 loan at a 3% markup) which will decrease your return, but I think it’s worth it to know your borrower has a solid payment history.
Do Additional Research on the Loan and the Borrower
Once you’ve found a loan where the borrower has made at least 6 on-time payments, it’s time to look at the details. The most important things to look for are the credit score, the loan purpose, and then whatever additional criteria you want to add.
Loan Purpose: Credit Card Refinancing / Loan Consolidation
If you take a look at the Lending Club Statistics, you’ll see that “Credit Card Pay Off” has the highest return of any Loan Purpose at over 10% (as of 6/25/2012). I like funding credit card payoff loans because it tells me the borrower understands personal finance well enough to know that a loan at 15% is better than a balance on a credit card at 24%. These people are taking out loans to SAVE money.
Compare that to someone who wants money for a business that might fail, a wedding that they obviously didn’t save up for ahead of time, or a vacation they can’t afford. These people are taking out loans to SPEND money, and I stay away from these loans at all costs. It doesn’t mean they are necessarily bad; it just means I don’t like them and historically they have had lower rates of return than credit card payoffs.
Credit Score Change: Down a Little is OK
Most of the “Never Late” loans for sale on FOLIOfn are there because a decrease in the borrower’s credit score has spooked the original lender. Sometimes a person’s credit score goes down from 780+ to 750-779. I love these loans because the person still has amazing credit. It might have dropped because they applied for a new credit card to get a sweet sign-up bonus or something. No worries here.
The problem comes when they go from the 714-749 range to 600-619 range. That shows a serious change in the person’s credit and I’d stay away from that entirely. You have to set your own threshold, but if they’ve dropped more than 60 points in their credit score since origination, I avoid the loan.
Additional Criteria: Do Your Research
So far you should be here:
- A “Never Late” loan with at least 6 months of payment history
- A Markup of 3% or less
- A credit card payoff or debt consolidation loan purpose
- Credit score drop of no more than about 60 points from loan origination
Once you get this far the loans are pretty good, but you still want to get rid of the bad apples. The best way to do this is to use this great tool at Nickel Steamroller that allows you to filter Lending Club loans based on different criteria. A combination of this tool and some common sense goes a long way.
One of my rules is that I don’t lend to people from California. I think their economy is terrible and I don’t trust anyone in that state to keep their job. You might think I’m generalizing, but using the data you see that total ROI goes up from 6.90% to 7.03% when you take out California borrowers.
Another good rule is to exclude anyone whose employment length is n/a, < 1 year, or 1 year. By making sure your borrower has had a job for at least two years, you increase ROI from 6.90% to 7.17%.
Come up with some criteria in your head that you want and then use the tool to check and make sure your hypothesis was correct. Sometimes you might be wrong. For example, I thought excluding loans from Michigan would improve the ROI and it actually dropped the ROI by 0.01%. Apparently Michigan borrowers are about as good as any other borrowers despite the bad economy up there.
If Someone Misses a Payment, Don’t Panic
Even after you’ve done all your research and picked the right loans, there’s a good chance someone might miss a payment. I suggest you don’t freak out and sell the loan for 50% of what it’s worth thinking you’ll never see another dime.
The fact is that 84% of loans that fall into the grace period are recovered, and 77% of loans that have a payment 16-30 days late are recovered according to Lending Club Statistics. Lending Club will be calling and emailing these people frequently to get them on a payment plan, so I like to ride it out and hope those people get back on track.
Trading Notes in Lending Club Can Make You Money
As always it is important to remember that you can lose money when you invest. It’s also important to own your decisions; I am happy to give you my suggestions but it’s your money and you are responsible for any gains or losses you realize.
If you think you want to give Lending Club a shot, you can sign up here.