Peer-to-peer loans have become an increasingly popular way for investors to diversify their portfolios, but some have failed to use these services properly and have left themselves unprotected. Make sure to diversify your loan portfolio to maximize your investment with Lending Club or Prosper.
On a recent online conference, the Lending Club team shared the story of an investor who put $500 in one loan. Unfortunately, the borrower defaulted on the loan and the investor was left with nothing. Lending Club is currently seeing about a 3% default rate, which is much better than what many banks are seeing. If the investor has instead invested in $25 in 20 different loans, it’s possible that one of those loans would have gone into default, but 95% of his portfolio would still be performing.
When you’re loaning money to individuals through Lending Club or Prosper, the law of averages comes into play heavily. When investing in small personal loans to people, you are going to see a 1-5% default rate depending on the individual’s credit history, their employment history, and the type of loan that they take out. When you spread your investment across just two or three loans, you are going to take a much bigger hit if the borrower does not repay their loan.
If instead, you spread your investment out to as many loans as possible, you are much more likely to see an average default rate instead of getting really lucky with no defaults or getting really unlucky with an unusually high percentage of defaults. It’s very analogous to playing the stock market. You can invest in a few companies and do very well or do very poorly or you can invest in a mutual fund and get a very competitive market average while taking on a lot less risk.
With Lending Club, investors have been earning an interest rate of 9.64% APY after all origination fees, late payments and defaults are subtracted. Having a small percentage of defaults is almost always going to happen when making these types of loans, but you just need to factor them into the rate of return that you earn. The key is to avoid statistical anomalies and position yourself to best get an average number of defaults. You can do this by making a very large number of loans and investing only $25 or $50 in each loan.
Lending Club recently had an investment strategy session with its investors and Scot Langmack, a Lending Club investor that has averaged over 12% gave just that advice. In fact, he suggested investors partially fund over 400 loans to fully diversify themselves and maximize their probability of receiving a high rate of return.