Somewhere in Mt. Pleasant, North Carolina, a guy is using my money to build a swimming pool at his house.
I know this because I lent him $25 through LendingClub, a site where ordinary people lend money to (and borrow money from) other ordinary people. Like other peer lending sites such as Prosper, LendingClub promises big returns (over 9.5% on average, after taking fees and defaults into account) if you’re on the lending side, and lower-than-credit-card rates on the borrowing side. The service currently has $18o million in outstanding loans to over 27,000 borrowers.
Since my landlord told me I’m not allowed to build a swimming pool in my apartment, I’m going to focus on the lending side of LendingClub. If you have some money to invest, should you hand it over, via LendingClub, to random people around the country who need a loan?
It takes about five minutes to sign up for LendingClub and a couple of business days to transfer money electronically from a checking account. Then you can browse “notes,” which are like bonds: they’re pieces of a loan. My swimming pool guy is also borrowing money from 310 other LendingClub users for a total of $15,000. LendingClub gives each note a rating. A-rated notes are the least likely to default and pay the lowest interest. G-rated loans are extremely risky and pay very high interest. Swimming pool guy is rated A5 and pays 7.66%. (So far, he’s on time with his first payment to me: 77 cents.)
The stereotype about peer lending is that you’re giving money to deadbeats who can’t get a loan elsewhere. That’s not the case here. “We’re not lending to everyone,” says LendingClub’s Rob Garcia. “We’re only lending to the top of the top of the credit spectrum.” Nine out of ten loan applications are denied as they make their way through a rigorous underwriting process.
LendingClub is not for everyone on the investing side, either. Investors are required to affirm that they have a net worth of $70,000 and gross income of $70,000, or a net worth of $250,000—not counting home equity. (These qualifications are waived if you want to invest less than $2,500.) There is a good reason for these qualifications, which I’ll explain in a minute.
If you’re investing a large sum of money with LendingClub, you can and should diversify by splitting it among dozens or hundreds of notes. The web site offers a tool for allocating your cash; you don’t have to select each note manually.
Which is nice, because browsing LendingClub notes is a little depressing. The majority are people seeking a debt consolidation loan to get out of credit card trouble. Meanwhile, my swimming pool guy reports a gross monthly income of over $12,000 but is borrowing $15,000 to build a swimming pool. Why? I don’t even want to know. Another guy wants to borrow $20,000, for 60 months, at over 20% interest, to buy an engagement ring. I’m crying, and not tears of joy for the happy couple.
Of course, getting despondent over the poor financial habits of Americans after reading LendingClub notes is like going to your local emergency room and concluding that everyone in your neighborhood is bleeding.
It’s not a savings account
When you put your money into a bank savings account, the bank turns around and loans it out to other customers. If you’re lucky, the bank will pay you 1% interest for the use of your money. LendingClub investors typically make a lot more than that. Why? There are three reasons.
1. LendingClub uses technology to lower costs. If you want to borrow money with LendingClub, you don’t have to sit down at a desk across from a banker. You submit your information, undergo a credit check and underwriting, and if you’re approved, people like me can start throwing money at you.
2. You’re taking all the risk. LendingClub is not FDIC-insured, and you can lose money. If my borrower goes bankrupt halfway through the construction of his swimming pool, I take a bath. I mean, figuratively. And swimming pool guy is one of their A-rated best bets.
3. LendingClub ties up your money in a way banks and mutual funds don’t.
This last point is important, and it’s the reason LendingClub only accepts relatively affluent investors: if you put money into LendingClub, you can’t necessarily get it out except by waiting for the loans to be repaid. “There’s a very good reason why these investments should be only for the rich,” writes Reuters finance blogger Felix Salmon, “and it has nothing to do with them being a high-risk gamble. Instead, it’s all about liquidity. If you lend someone money for three years, your money is essentially out of reach for three years.”
Furthermore, LendingClub recommends investing at least $20,000 across 800 notes for maximum diversification. Few financial advisors would recommend investing more than 10% of your portfolio in high-yield debt, which implies that LendingClub’s perfect customer has a portfolio of at least $200,000.
LendingClub offers a trading platform to sell notes before maturity, but it’s not like selling a bond, where the security is priced daily and your broker will be happy to take it off your hands for a set fee. You might have to sell your note at a steep discount, especially if interest rates have gone up since the loan was originated. “If you price your notes at par value or at a discount, you can get rid of them within a few days,” says Garcia.
I put my swimming pool note up for sale at its par value. It’s a current, highly-rated loan. Two days later, no one has taken it off my hands. (It typically takes about 5-1/2 days to sell a note at par, according to LendingClub.)
Is LendingClub for you?
In order to make LendingClub part of your portfolio, you need to know more than just how risky it is in isolation. You want to know how it works alongside other asset classes, like stocks and bonds. And that information isn’t forthcoming, because notes are hard to trade and aren’t priced daily. We can make a guess, though, that LendingClub notes perform similarly to high-yield bonds (aka junk bonds). The popular SPDR Lehman High-Yield Bond ETF (JNK) yields about 8%—comparable to LendingClub—and you can sell out of it anytime.
LendingClub, however, has a lot to recommend it. It represents the good kind of financial innovation, and the underlying assets aren’t incomprehensible derivatives; they’re just plain vanilla loans.
Even if you use its AutoInvest tool, LendingClub demands that you get your hands dirty in a way that mutual fund investing doesn’t. And that’s exactly what some investors are looking for. A person who enjoys day-trading stocks or currencies—fantastically effective ways to lose money—might well find it just as fun but far more lucrative to select LendingClub notes.
(One more thing: LendingClub notes should be held in an IRA or Roth IRA if possible, because they’re tax-inefficient: unlike capital gains or qualified dividends on a stock, their interest is taxed at higher ordinary income rates.)
I hope Swimming Pool Guy is out back right now with a shovel, and I wish him three years of Speedos, suntans, and on-time payments.