Posted on January 1, 2019
Peer-to-peer lending has exploded in popularity over the last few years as interest rates stayed at historic lows. Investors have been desperately seeking yield and rightfully so. Peer-to-peer lending has provided an attractive alternative to low yield treasuries and certificates of deposits. However, these lending platforms carry significant risk – more risk than the returns provide. Below are the dangers of the two most popular lending platforms and why you should stay away from them.
Returns Do Not Justify the Risks
These loans are very risky. Do not be fooled by historical returns or credit quality ratings. The Lending Club (TLC) and Prosper both claim a 5.5% average historical return rate. That return simply is not good enough relative to the risk one assumes.
Compare that to what banks receive for the same type of risk. Interest rates are roughly 17.15% on average for unsecured personal loans. In addition to the higher interest rate the banks are also earning swipe fees for every transaction. Interest rates do not equate to return percentages since defaults and overhead fees are not included. However, it would be fair to say the returns are much higher than 5.5%.
TLC and Prosper provide their own proprietary credit rating methodology, generally in the form of grades from A to E for TLC and from A to D (and HR) for Prosper. We don’t know how good an A rating is and we don’t know how bad an E rating is without understanding the methodology used to derive these ratings. Unfortunately since neither company discloses their methodology we can take very little value in their ratings.
Material Information is Not Provided
Verified income of the borrower is an extremely important factor in evaluating the ability to pay. Unfortunately TLC and Prosper do not verify income for all loans as verification appears to be discretionary. Remember the subprime loan crisis? That was in part fueled by banks not verifying income of the lenders.
Both companies are quick to provide revolving credit balances of the borrower but they do not provide non-revolving credit. Revolving credit is typically credit card and personal loans whereas non-revolving credit is student loans, auto loans and mortgages. How on earth can one assess the ability of the borrower to repay a loan if total debt (revolving plus non-revolving credit) is not provided?
No Control Over Default Recoveries
If a borrow defaults on a loan you have no control on recovery of the loan. Control is entirely up to the company’s discretion. To add insult to injury you also are charged fees, up to 40% in some cases, for any amounts recovered.
You Are Paying to Invest
This violates the Contrarian’s investing guide. You should not have to pay any fees for investing. Both TLC and Prosper charges the investor 1% of the loan in addition to collection fees if a loan defaults.
Bankruptcy Risk by TLC and Prosper
In addition to the risk you are assuming by participating in individual loans, you are also assuming risk by the company itself. If the TLC or Prosper becomes insolvent you are then an unsecured creditor of the company according to the prospectuses. This means that even if all of your individual investments were paid off you might still recover little to nothing in the event of default by the company. Keep in mind both companies have not been and are not currently profitable.
Websites reviewing and recommending TLC and Prosper are most likely doing so because they are getting a commission from it. Both companies offer affiliate programs whereas the recommender is receiving money for any referrals.
Untested Through a Recession
We simply do not know how these loans will perform in a recession. However, it would be reasonable to guess it could get ugly with significant rises in default rates that will negatively affect returns. Worse yet it might take these companies into bankruptcy but it is impossible to predict the future.
The Bottom Line
My recommendation is to stay clear of these types of peer-to-peer lending platforms as the risks appears to be higher than the potential rewards. If you are looking for alternatives I would recommend having a look a U-Haul’s peer-to-business lending program.