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Lending Club Risks and Costs

People keep asking me for my thoughts on Lending Club. I finally capitulated last week and read the prospectus and accompanying supplements/disclosures. My thoughts are as follows:

High-risk, high-yield lending isn’t new. Investors have had access to such investments for the last few decades. They’re called junk bonds.

In fact, it may be illuminating to compare Lending Club notes to just such an investment. Let’s use iShares High Yield Corporate Bond ETF (HYG).

(Admittedly, Lending Club notes may offer some feel-good value or entertainment value not offered by lending to businesses. I, however, find it just as fun to lend to a business as to a person. So for this comparison, I’ll assume such value is zero. That may not be the case for you.)

Fees & Expenses

From page 4 of the Lending Club prospectus:

“Prior to making any payments on a Note, we will deduct a service charge equal to 1.00% of that payment amount….The service charge will reduce the effective yield on your Notes below their stated interest rate.”

So, for example, if a note had an 8% yield and every payment was received on time, you’d earn a 7% rate of return.

The annual expense ratio for iShares High Yield Corporate Bond ETF is 0.50%, half that of Lending Club notes.

Advantage: iShares High Yield Corporate Bond ETF.

Diversification

With the ETF, you’re immediately diversified among several different borrowers. With Lending Club notes, you have to do it manually. In other words, diversifying a portfolio of Lending Club notes requires a) more time, and b) more money than diversifying a portfolio of high-yield bonds.

Advantage: iShares High Yield Corporate Bond ETF.

Liquidity

Lending Club notes can be sold on their Note Trading Platform, operated by FOLIOfn. When selling Lending Club notes, you name an asking price and hope to get it.

When selling an ETF, you have that same name-your-price-and-hope-to-get-it  option, or you can simply place a market sell order and know that your shares will be sold almost immediately and that you’ll get a price very close to the price of the last trade.

Advantage: I can’t be absolutely certain because I don’t have any data about sales of Lending Club notes, but I think we can safely say that it’s either a tie or a win for the ETF.

Liquidation Costs

FOLIOfn charges a fee equal to 1% of the price of the sale of Lending Club notes.

ETFs can be traded at your brokerage firm of choice. The commission will depend upon that brokerage firm’s commission structure.

Advantage: It depends upon your brokerage firm and upon how much you’re selling. For example, if you use TradeKing ($4.95 commission/trade), and you’re liquidating less than $495 worth of the investment, Lending Club notes win. If you’re liquidating more than $495, iShares High Yield Corporate Bond ETF wins.

Company-Specific Risk (SIPC Insurance?)

If the brokerage firm where you buy and hold your ETFs goes bankrupt, you’ll be covered by SIPC insurance (up to $500,00 per investor). In contrast, per page 20 of the Lending Club prospectus:

“If we were to become insolvent or bankrupt, an event of default would occur under the terms of the Notes, and you may lose your investment.”

Also on page 20:

“We have not been profitable since our inception, and we may not become profitable.”

In short: In addition to the borrower-specific risk, you’re taking on company-specific risk. Specifically, the risk of a start-up company that has yet to show a profit.

Advantage: iShares High Yield Corporate Bond ETF.

Default Risk

Unfortunately, when Lending Club provides default data, they tend to include every loan that has been issued for 45 days or more. As you can imagine, most loans haven’t defaulted by just 15 days after the due date of the first payment. In order to make a meaningful comparison, we’d need data on loans that have gone full-term.

Thankfully, Lending Club does allow you to download a good deal of data regarding their past loan performance. That’s where you can find facts like these (as of 1/22/2010):

  • Of loans more than 30 months old, 11.63% of loaned principle is either in default or has been completely charged off.
  • Of loans between 27 and 30 months old, 15.71% of loaned principle is either in default or has been completely charged off.
  • Of loans between 24 and 37 months old, 18.49% of loaned principle is either in default or has been completely charged off.

On the other hand, as bad as those default rates appear, they should be accompanied by a few caveats:

  • They occurred during a significant economic downturn,
  • The sample size (in terms of time covered) is quite small, and
  • The default rates for Lending Club’s highest-rated notes are much lower.

Advantage: Neither. There still isn’t enough data to say either way.

Interest Rate Risk

According to Morningstar, the average effective duration of bonds included in iShares High Yield Corporate Bond ETF is 4.25 years. They don’t list the average maturity, but by definition it must be longer than 4.25 years.

The maturity of every Lending Club note is 3 years.

Advantage: Lending Club. Due to their shorter maturity, the market value of a Lending Club note should fluctuate less dramatically than the market value of iShares High Yield Corporate Bond ETF as a result of changes in market interest rates.

Summary

To be clear, the above comparison is very back-of-the-napkin. Because of their high overall default rates, I’ve compared lending club notes to junk bonds. However, a more meaningful method would be to compare each grade of Lending Club notes to a different bond ETF. (The idea would be to match up each grade of notes with an ETF that invests in bonds with similar historical default rates.)

Unfortunately, as I mentioned above, sufficient data does not yet exist for such a comparison to be made.

As it stands right now, I’d categorize Lending Club notes as short-term, high-risk debt that’s difficult to diversify and that carries somewhat higher expenses than I’d like. Entertainment/feel-good value aside, I don’t see much purpose for Lending Club notes in most portfolios.

Of course, a few years from now, the data could prove me wrong.

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Comments

  1. Good analysis!

    The one thing with your comparison of ETFs to Lending Club are their betas. With Lending Club obviously each account is different and will yield different results. Based upon the ETF graph on Morningstar (no beta # was available) it appears it’s beta would be much higher than most Lending Club investments. I’m not sure comparing Lending Club’s returns to junk bonds is completely accurate. IMHO I believe they are slightly better than junk bonds and you CAN choose only A graded loans if you wish. I consider Lending Club somewhere between high rated corp bonds and junk. More closer to junk though. So maybe comparing to another fund might be in order.

    The other thing you don’t mention with Lending Club is taxes compared to an ETF. Lending Club is taxed as ordinary income. So I assume the ETF will win on this. It’s been said in a few places you are best putting Lending Club investment in an IRA.

    I do a review of Lending Club myself and also list possible risks:

    http://investorjunkie.com/lending-club-review

    One thing you don’t mention is will Lending Club properly price the borrower’s risk to default. I believe this is the biggest risk you have with Lending Club. This is where previously Prosper failed miserably. Lending Club does have some skin in the game and they do partially fund many of the loans.

    I personally have investing with Lending Club (only 1k at the moment) but do plan on increasing the amount invested. I’m putting only a little money in and do plan on updating my blog with results. So far I can’t complain with my results. I’m over 6 months in and 10.77% return with no defaults and sold a loan that I thought was going to go sour before it did.

    For me, at least, I so far can’t complain about Lending Club and will be interesting in 2.5 years to see my end results.

  2. Hi Investor Junkie.

    As to the tax differences between a bond ETF and Lending Club notes, I don’t think there is much. In either case, the interest from the debt will be taxable as ordinary income, and any gains resulting from a situation in which the investment is sold above basis will be taxed the same whether the asset was an ETF or an LC note.

    As I mentioned above, I’m in complete agreement that a more meaningful comparison would be to separate Lending Club notes by credit rating, comparing each grade to a bond fund with similar default risk. Still, I don’t think that 2.5 years of data is enough to make any meaningful default risk comparisons.

    As to Lending Club partially funding many of the loans: As a potential Lending Club investor, that would scare me more than it would comfort me. If Lending Club goes belly up, so does your investment. The fact that Lending Club’s own capital is invested in Lending Club notes makes the company (and therefore loans via the company) higher risk rather than lower risk, in my opinion.

  3. It comforts me they are just not pricing these loans willy-nilly. If they have skin in the game, they want to make sure they get a ROI. Prosper did not and just made the money on selling them.

    If LC goes belly up, based upon the prospectus it should be ok and not a complete loss.

  4. “If LC goes belly up, based upon the prospectus it should be ok and not a complete loss.”

    What makes you say that? Or perhaps, what do you mean by “should be ok”?

  5. Thank you for sharing that Q&A.

    However, given the actual wording of the prospectus…

    “If we were to become subject to a bankruptcy or similar proceeding, the rights of the holders of the Notes could be uncertain, and payments on the Notes may be limited and suspended or stopped. The Notes are unsecured and holders of the Notes do not have a security interest in the corresponding member loans or the proceeds of those corresponding member loans.”

    …I’m still not exactly convinced that LC bankruptcy isn’t a meaningful risk.

  6. Unless I’ve got text blindness, you haven’t compared the yields? I might be prepared to take on all that hassle for an appropriate yield.

    The nearest thing we have in the UK is Zopa, which I understand withdrew from the US about 12-18 months ago.

    I overall like the offering, but I was hit with a spate of 2-3 bad loans for c.£10 which significantly reduced my overall return. (I was investing just less than £1,000 as an experiment).

    Clearly this was bad luck and not statistically relevant, but it did spook me. Two of the loans were originated in the same week, too! At least you get the Saturday boy impact averaged out when you invest in a normal bank. ;)

    A more universally unattractive feature for lenders (as opposed to borrowers) is that the entire loan can be repaid with Zopa at any time, with no penalty. That effectively makes them callable bonds, and really skews the risk/reward. Don’t know if that’s the case with TLC?

    As I say, I think it’s a fun and welcome innovation, but I wouldn’t trust it with more money than I’d put into a single stock. It’s definitely not the same as a savings account.

    I don’t suppose TLC’s affiliate scheme has hurt its currency as a topic of choice on the financial blogs! But I’ve no experience of the service, so can’t comment beyond those Zopa comparisons.

  7. @Monevator Yes LC loans can be paid off at any time.

  8. @Monevator:

    I did not compare the yields–reason being that until we have a larger data set for examining default risk, I’m not sure comparing yields offers much value.

    Yes, there is prepayment risk with LC notes, but there is with junk bonds as well. After a few more years, we’ll have better data on whether LC notes have a higher or lower prepayment risk.

    These two points help highlight my basic view of LC at this time: Wait. If it’s still around in a few years, there will be more data, and perhaps it will be a profitable company. Until then, using anything more than play money seems a poor decision to me.

    “I don’t suppose TLC’s affiliate scheme has hurt its currency as a topic of choice on the financial blogs!”

    No joke. Now, to be clear, I make money with affiliate programs as well, and I have nothing against them in general.

    But I think the manner in which most Lending Club “review” posts are written is, frankly, irresponsible. From what I’ve seen, most of the review posts are written by people who have:

    1. only recently opened an account,
    2. not read the prospectus, and
    3. not bothered to look into any data beyond that which Lending Club prominently features on its site.
  9. @Mike: “But I think the manner in which most Lending Club “review” posts are written is, frankly, irresponsible. ” 100% agree! This not only applies to Lending Club but many other “reviews” on the web and it seems like an issue in the PF blogosphere. With anything on the web it should always be buyer beware! For me personally, I have no problems discussing the negatives of Lending Club or any other service I recommend. I also believe the only want you can give a in-depth review is actually using the product/service. In my case I do plan on keep my readers informed of my experience.

  10. Mike,
    You make some good point- the 1% is high and I agree waiting for more data is prudent- as it’s hard to characterize performance without a long track record. I’ve got an account with a very small balance to experiment with and so far it has worked out well.

    I really like the idea of peer to peer lending- a credit market that anyone can participate as a lender or borrower. Why should banks own all of the personal loans?

    I hope someone gets it right- ideally credit markets would be accessible by many different brokers like the stock markets, and there would be regulations to insure your money is recoverable if the broker goes bankrupt. I would love to see Vanguard offer peer to peer lending with a 0.10% fee… but that may be a long while. I would also like to see peer to peer lending use collateral as it should lower default rates.

    -Rick

  11. Does anyone know a regular bank, how much of the interest rate is for maintenance? I think that would be the best way to determine is Lending Club’s 1% more costly than a regular bank. Lending Club was originally 0.5%, so assume they quickly found out that was not sustainable. Keep in mind they have to generate statements, do collections, get info from credit agencies, review loan applicants.

    @FS: I reviewed my current statement and it’s 1% overall invested, not your return per loan. See this page for more info:
    https://www.lendingclub.com/public/rates-and-fees.action

    @Mike: also cash balances are FDIC insured (not in the notes)
    https://www.lendingclub.com/public/faq.action#l5

  12. I think if done right, peer to peer lending is a great alternative investment in the long haul, and more and more companies will start offering this service (there may even be an ETF in the future to track this).

    You made a good comparison, but I feel that both have its place just as the S&P 500 index fund and the S&P Dividend index fund have their respective niches. At the end, it provides choices and possible diversification right?

    1% is not low by any means, but it’s not considered high in the investment world. I do however feel that Folio’n (the place that lets you buy and sell the the notes) are ripping people off with the 1% charge.

  13. I am @michaelrpiper on twitter. :)

  14. @InvestorJunkie @Mike – Thanks for the info.

    I think the repayable nature of these peer-to-peer loans is seriously unattractive as a lender, as I say.

    Firstly, it makes judging the value of an investment and planning ahead difficult, as with all callable bonds.

    My other concern is that the best individuals sort out their finances, repay their loan (even if by getting another cheaper one) the P2P lenders will slowly accumulate poorer borrowers who can’t or won’t repay… so the risk of a loan portfolio goes up over time?

    This could feasibly be a bit of a timebomb for P2P operations – that their loan book is slowly deteriorating.

    At the least there should be a small charge for early repayment – something most venerable high street lenders usually ask for, no doubt for this very reason!

  15. Something else to highlight on the comparisons…
    1: To actively invest into the loan prior to it being fully funded you have to have $70,000 yearly income. In CA it is higher.
    This is an IRS rule not theirs. Its deep down in the prospectus and I had to twist their arm to admit it over the phone. They tried to use the cover of “we aren’t allowed to answer tax questions.” In fact they would not answer it over their chat program but asked me to call them for the answer. Presumably so it would not be traced or recorded.

    After a loan has been funded the notes can be sold on Lending Club’s market and there is no longer that $70k restriction as it falls in the over the counter debt catagory. The con to this is that you have to pay whatever price the seller wants. I usually find that a 1 extra payment fee is what is asked. E.G. if its a $25 getting $0.80 payments every month they will sell it for $25.80. This will further erode your earnings.

    2: However it raises a possible interesting strategy. Lending club takes their 1% cut when you sell a note and in the above example get $0.55 profit, 2.2% return. Lending club says it takes an average of 3 days and 20 hours to sell a note. If you did this every month and sold it before any default would occur, prior to the first payment failing, you could theoretically get 26% return. Doubtful the reality would be that but I find it interesting none the less.

    3: There is a pro to not funding a loan but buying it off the market after the fact. You can see how the payment schedule goes and Lending Club continue to monitor their credit rating. My hope is I can avoid some risk of the people who don’t pay from the start or whose credit drops by 100+ points presumably from being late on other payments or from asking more credit and more loans elsewhere.

    Still I agree. Its too early to tell and I wouldn’t really say I am investing with Lending Club as I am in playing around with it.

  16. Great article and comparison, got me thinking, but having invested $10k+ on Lending Club for more than 2 yrs at an annual yield of 6.9% (after bad loans and some fees) makes me definitely happy I chose this over a corporate bond for 2 reasons: 1) the reward of lending to people directly and know I’m helping someone get a better rate and 2) the fact that LC notes do not seem to be behaving as volatile as the stock market… yes, I have had my share of defaults, but so far, the returns are good.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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