Secrets of Successful Peer Lending Investors Exposed
This section will uncover the strategies Lending Club investors use to minimize risk and maximize their returns.
Tip #1 – Diversification
The most successful investors never concentrate their investments in a single Lending Club note or notes. Instead, they allocate their funds across at least 100 or more notes. For instance, if an investor has $1,000 to invest, then he/she will allocate $10 across 100 notes to reduce the risk and impact of defaults. By creating a portfolio of many notes, the expected result is likely closer to the industry average default rates. In addition, the greater number of notes invested in, the less impact a single default has on the return.
Tip #2 – FICO Scores
Borrowers with high FICO scores have the lowest default rates even during the worst recession. Another way to look at this is those with higher FICO scores rarely default while those with the lowest FICO scores default more often. For instance, those with a FICO score of 740 or greater have a default rate of less than one percent. Lending Club only deals with borrowers who have a FICO score of 660 or greater. In other words, investors are only purchasing notes from prime borrowers—not sub-prime borrowers. Investors that want to further reduce exposure to defaults with prime borrowers will purchase notes with high FICO scores, sacrificing some potential interest return upside.
Tip #3 – Seek Those with Job Stability
This tip goes hand-in-hand with tip #2. Those with good credit will work hard to keep it that way. However, the one thing the credit score does not reveal is job stability. All things being equal, someone who has jumped from job to job but pays his/her bills on time will have the same score as someone who has been at the same job for over 10 years. So how do the most successful Lending Club investors invest based on job stability?
They do not invest in borrowers who:
- Have only been working at their current employer for a very short time.
- Work for companies that have hit hard by the recession (i.e. automobile, financial, real estate)
- Do not appear to have a job or job skill that is in demand. In other words, if the borrower was laid off, would he/she be able to easily find another job at the same pay level or higher.
Based on this information, savvy investors look for a borrower who is better positioned to withstand a tough economy for two to five years such as:
- Government employees with a long tenure.
- Workers in the health care industry, especially fields with known shortages of the labor pool.
- Employees at stable companies with a long tenure.
Tip #4 – Think Twice About Business Loans
Most of the Lending Club investors do not invest in business loans. These are one of the most risky notes no matter what the borrower says. The following are a few examples of business loans that one might encounter.
- The borrower needs a loan to provide an existing business with capital. In this case, the borrower is using personal credit to sustain the business. There could be a couple of reasons for this need. For instance, this might be a last ditch effort to keep the business from going bankrupt. Alternatively, the borrower might be a victim of tighter bank credit. There really isn’t a way to tell which is the case.
- The borrower is still has a job, but wants a loan to start a business. In this case, it is important to review the amount the borrower needs. If the loan amount is greater than what they can pay back through their job, then steer clear of this note.
Also, one must realize that 90% of new businesses fail within the first five years. It is no wonder why most Lending Club investors avoid business loans in general.
Tip #5 – Reinvest Interest & Principal
Lending Club investors do not let repaid interest and principal just sit idle. They reinvest in additional notes to take advantage of the power of compounding interest. Simply put, compound interest is interest earned on reinvested interest as well as the original amount invested. There are numerous examples of the power of compound interest. A very simple one to understand is the “dollar a day” graph below.
In this graph, the parents or grandparents of a newborn baby begin saving one dollar a day from the baby’s birth and each year that is invested into a vehicle with an average annual return of 9%. When the baby gets older they continue investing one dollar a day until they are ready to retire at age 65. While the total investment over this period is $23,725, the actual value of the account, though, is now $1,094,375 because of the power of compound interest.
BONUS: Other Investment Considerations
In addition to these tips, successful investors target a specific goal for their portfolio when constructing a portfolio of Lending Club notes. For instance, the most conservative approach would be to target the loans with the highest credit rating because the default risk is extremely low. The returns for these kinds of notes may vary between 6% and 8% factoring defaults and fees. An investor pursuing this strategy will forego the chance of higher returns (9% or above) in exchange for lower risk.
Other investors who pursue and achieve higher returns only target notes with a certain interest rate and never invest in anything below that rate of return. In this case, an investor who wants to achieve an average of 12% return may decide not to invest in any note below 11%. In addition, this investor will allocate more time to scrutinize the borrower’s job profile to identify job stability and minimize default risk.
Even after employing these tactics, an investor pursuing a higher return will assume a higher level of default risk. Subsequently, the higher return investor may invest in higher return notes assuming a certain percentage of notes may default. For instance, if the investor is seeking an average of 12%, he/she will add notes offering 14% or higher and assume some of those notes will default.
What Next?
Now that you’ve finished reading, are you ready to start putting what you’ve learned into practice. Here’s a quick step-by-step guide to take your learning to the next level.
- Identify your target rate of return and risk tolerance.
- Open a free account at Lending Club.
- Identify notes to fund.
- Review the borrower’s credit history, intended use of funds, and ability to repay the loan.
- Reinvest the re-paid interest and principal.
