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Investing for Arborists, Part III - Lending Club

 

I learned about peer lending relatively early on in my financial life, as I was looking for ways to hedge against having only one type of investment as well as earn the best possible returns on those investments. Eventually I came across Lending Club and after a fair amount of testing the waters, I now have a substantial portion of my investments held in notes from the platform (more on the terminology briefly). At its simplest, peer lending is a way for individual investors to lend money to individual borrowers with a minimal amount of effort and dealings with middle-men. As an investor, you're given the opportunity to select from thousands of loan applications to partially fund based on basic information supplied by the borrower, such as loan purpose and credit history. Tens or hundreds of other lenders do the same thing, and eventually the loan is funded and all investors receive interest over its lifetime of either 3 or 5 years. Executed properly, peer lending can be an excellent addition to any investment portfolio.

Terms

So let's get down to details, starting with some terminology. Being a Lending Club lender, you'll do most of your interaction with the site in the form of browsing for notes. A note is simply a fraction of a loan that you can purchase through the platform, and it can vary in value from $25 all the way up to the entire value of a loan (if you're so inclined; I wouldn't advise it). Notes are the basis of all investing and reporting on Lending Club, and if you're a serious investor, you'll end up with a lot of them.

There are also a lot of note-specific terms that I'll try to summarize here. Grade is a letter-grade representation of the "quality" of the credit for the borrower behind each note. Higher grades generally equate to lower risk, lower return notes and lower grades gradually scale to higher risk and return. Term is just the number of months that the loan will last assuming the payment schedule stays the same (but borrowers are not penalized for paying loans off early, so any note can be done in as little as one payment). Loan purpose can be any of a handfull of high-level categorizations that Lending Club tracks on their platform. "Debt consolidation" (or refinancing, as they've recently started calling it) is by far the largest reported purpose, with credit card payoffs a distant second.

Now let's assume you've been buying up notes for a while and you're starting to amass interest income. This is where your net annualized return comes in. Lending Club reports your earnings to you in a few different ways, and one of them is called net annualized return (NAR). There's a lot of good information on the site about this measurement and why it's a reasonable way to assess your current portfolio performance that I'll leave to Lending Club to explain, but I'll sum it up as best I can: NAR measures your portfolio performance as of now; it doesn't include any kind of projection or simulated data to come to the final numbers it displays. It shows your effective earning rate at any given moment.

So what if you actually want to view a forward-looking projection of your earnings? Lending Club has you covered with adjusted net annualized return (ANAR). ANAR calculates your returns based on some adjustable assumptions about your portfolio performance. The tool has some default values based on historical platform performance in the form of expected loss percentages, but you can override all of them with your own values to simulate best- and worst-case scenarios. For instance, later on in the article I'll show you my own absolute worst-case numbers from here. There's information on ANAR contained in the links above for NAR, so make sure you don't miss that.

And we come to PRIME. No, it's not the same Prime you may be thinking of that gives you free expedited shipping and unlimited video streaming from one of the largest online retailers in existence; this is the Lending Club version, and it has to do with automation. As you'll learn very quickly as an investor, it can be challenging to get all of your available cash dropped into notes. PRIME eases that pain by allowing you to set up some search parameters that it will use to invest your money into matching notes automatically on a schedule. The platform has a multitude of available filter criteria, but some of the important ones are grade, term, and number of delinquencies in the last two years for the borrower. You'll also be able to specify a maximum investment per note - an important diversification option. Finally, and most importantly, PRIME allows you to set target allocations for each grade of note, making it easy to tune your overall expected performance any way you like. There is no additional fee for PRIME, and you can suspend it any time you like.

Finally, there's portfolios. A portfolio in Lending Club is simply a collection of notes. Your use of these collections is limited only by your imagination, but generally I use them to group notes under different "strategies" that I want to compare. Unfortunately, you can't do much in the way of analytics for your portfolios; you get a breakdown of each portfolio's basic statistics, but you can't do any kind of advanced reporting, or view (A)NAR for just one of your portfolios, which limits their utility outside of managing groups of notes.

Whew! That was a lot to take in, I'm sure, but hopefully all this jargon will prepare you to start thinking about and using the platform with less stress. If I've missed something important, please feel free to let me know, or drop a note in the comments below. Now that we've got terminology out of the way, let's talk strategy and results.

Strategy

My strategy with Lending Club is about the same as it is any other kind of investment, and that revolves around the idea of maximum diversification. With rare exception - and all of the exceptions have been mistakes on my part - I do not invest more than the minimum in any one note ($25). In practice, this should mean that I never invest more than $25 in any one person's loan, which is the most important and effective way to limit my risk; if one person defaults, I lose a maximum of that $25, whereas if I were to invest more, a single failure could lead to significantly worse losses. There was a time when I limited my investments to grades A-C, but I don't worry so much about that anymore. My current target allocations for each grade, in case you're interested, are: A&B: 0%, C&D: 30% each, E: 25%, F: 10%, G: 5%. As I touched on above, these numbers are entered into my PRIME settings so that I don't have to constantly try to re-balance my portfolio. This allocation is only provided for reference - you should pick the allocation that makes you most comfortable and provides you the expected returns you want. As far as strategy goes, that's about it. Some people that I've talked to have some very serious and complicated investment strategies, but I find the results that I've gotten so far to be more than adequate and not warranting the significant expenditure of effort that some of those strategies entail.

Results

And now for the fun part: results! Before I present this, the standard disclaimer applies: these results are specific to my own account and there's nothing guaranteeing that yours will be the same or even similar. Now that we have that out of the way, here's some background on my account. I opened the account in August 2011 with an initial investment of around $100. For several months, I didn't invest much; this was my "testing the waters" period where I just wanted to get an idea of how the platform worked. Within the last couple of years I've ramped up my investments significantly and Lending Club is no longer a second-class citizen in my portfolio, but even now my earliest 5-year loans may still remain in play, depending on how quickly the borrowers have repaid their balance. Based on the default values of the ANAR tool I mentioned earlier, my returns are sitting just a hair above 10% at 10.01% (shown in the title image for this post). I decided to run a worst-case projection as well, and assuming that every late note eventually defaults, my return is still surprisingly healthy:

ANAR of 8.64%

Getting Started

Getting started as an investor is easy - just go to the site and sign up for an account. Be sure to browse through their knowledge base for investors to get an idea for how the program works and what the reqirements are (sadly, residents of some states such as Texas are not currently eligible - see the note trading platform as a possible alternative). After a brief period of identity verification and initial funding, you'll be ready to start investing! If you have any questions that I haven't covered here or just want to add to the conversation, feel free to drop a comment below or send me an email.

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