I began investing at Lending Club in 2011. When I first started, investing was largely the same as it is today. Back then it was easy to see that Lending Club was where I could earn interest by lending money to people. I recall looking at the Lending Club website and saying to myself, “Ok, so borrowers make monthly payments until the loans are paid in full, and I just take these payments and invest in more loans.” I remember thinking, “This is simple. This makes sense.” So I signed up.
Lending Club’s website does not have a list of tips for increasing returns
Today in 2014, investing at Lending Club is still simple. But like 2011, Lending Club’s website does not really have a list of tips for investors to increase returns. And if you’re like me, you want to earn the highest return you can. To help out new investors, I’ve listed the seven main strategies that people use to increase their returns. We’ll start with the simple ones and then move on to a few more advanced approaches. Let’s get started.
5 Simple Ways to Increase Returns at Lending Club
#1: Diversify your account in 200+ notes
The simplest, most powerful and important thing every single investor needs to do is diversify their account. Nothing else compares. When I encounter people who have a negative experience at Lending Club, the main reason for their troubles is usually their own failure to spread their investment across enough notes. Here’s a comment someone left on LendingMemo’s site last year:
“I speak from experience that this is a good way to lose your money with almost no recourse. I invested in 12 loans rated A or B, and 8 defaulted.”
This investor likely lost 60% of his invested cash, but that is because they were poorly diversified. If just one default happens to a person who invests across only twelve notes, that is an 8% loss on their investment — all of their returns are instantly wiped out. However, if you diversify across 200 loans and a single loan defaults, that’s a loss of just 0.5%, a much smaller hole to climb out of. And almost every investor will experience defaults, so this is something we need to prepare for.
As seen in Lending Club’s chart above, if you diversify your investment across hundreds of loans it is actually sort of difficult to lose money. Actually, there is a small debate about what the correct point of diversification is, but most agree it is 200 loans. Stick to at least that number or more and you’re very likely to have a positive return. Of course, since the smallest note you can purchase at Lending Club is $25, this means the minimum investment for people is generally $5,000.
#2: Keep your account fully invested
As our loans get paid back, the cash will begin to build up in our account. This uninvested cash earns no interest, so we have to keep reinvesting it or else it brings down our overall return. The easiest way to stay fully invested is to activate Lending Club’s Automated Investing tool. This tool will automatically reinvest any available cash into additional loans using whatever loan grades you select beforehand. You can even invest using a filter. This tool makes peer to peer lending a near-passive investment!
If you don’t feel comfortable using this tool, or have really specific filters that the tool fails to grab (IE: F and G-grade loans), then it is important to set up a rhythm or schedule to do this yourself. Lending Club adds new loans to their platform at 6am, 10am, 2pm, and 6pm PST (pacific standard time) each day.
Read more: Cash Drag in Peer to Peer Lending
#3: Increase the risk in your portfolio
When most people begin at Lending Club, they start with the safer A and B-grade loans. But as time goes by, many begin to feel more comfortable with it, and decide to take on more risk. The reason? Higher returns. Here is a chart Lending Club has released showing investor returns by loan grade:
As you can see, people who take on higher risk begin to experience higher returns, the best yearly ROI being in E-grade loans @ 9% (surprisingly, not at F/G-grades).
However, focusing your investment away from the safer A and B-grades and into the riskier C-G grades also means you are increasing the likelihood that your investment’s return could go down. In a bad economy the unemployment rate goes up, so more borrowers than normal default on their loans. The investments hit the hardest are those that focus on riskier borrowers (the lower loan grades); safer A-grade loans default way less often. So you will need to choose the level of risk for your account that is right for your particular situation.
#4: Filter for loans with no previous inquiries
Lending Club actually does a great job at assigning these loan grades. The technical term for this practice is called ‘pricing’. Interestingly, Lending Club’s pricing isn’t totally accurate. For example, some B3 graded loans perform better than others (courtesy of NSR):
As you can see, we can increase our overall returns by doing a bit of extra filtering ourselves. The subject of filtering is probably the most complicated corner of peer to peer lending, and the vast majority of investors (including myself) don’t really feel complicated filtering is worth the time commitment. However, simple filters like Inquiries in the last 6 months=0 continue to be great. This particular one is used by almost every investor who filters his or her loans.
You can find the Inquiries filter in the sidebar on the left side of the Browse Notes screen. Slide the slider down to zero and click Filter. One click and (historically) you have increased your ROI by 1% or more. Of course, there is no guarantee that this filter will continue to work forever, but in November 2014 it still seems to be the case.
Read more: The Filters I Use to Invest at Lending Club
#5: Invest through an IRA
Right up there with the miracle of compound interest is the benefit of tax-free accounts. And most investors don’t realize how ugly taxes can be on peer to peer investments. This is because peer to peer investments don’t have a special tax rate like capital gains does (stock market investing). Instead, you will pay the same rate that you earn on something like a savings account. For some investors, this means they lose 30% of their p2p earnings to taxes.
Lending Club helpfully offers their lenders the ability to open a self-directed IRA (regular or Roth) or roll over a 401k, and the benefits of a self-directed IRA are stunning. Say you are 35 years old and open a Lending Club IRA with $5,000, adding $5,000 per year that grows at 8% and closing it when you retire at age 65. With the IRA you would end with an account worth $662,000. If you used a taxable account all those years and were in a 30% tax bracket, you would have just $414,000. That is a tremendous difference of $250,000.
You give up liquidity with an IRA.
Of course, you give up liquidity with an IRA, which means you are limited in your ability to pull your money out if you suddenly need it. Most people exit a Lending Club IRA by transferring it to another investment, which requires paperwork, or by withdrawing it in cash, which means you get hit with a penalty. So if you’re an investor who doesn’t feel comfortable locking money up in Lending Club for a lengthier time period, you may want to stick with a regular taxable account.
That said, I personally invest through a Lending Club IRA (see my returns) because I trust this investment so much, and this strategy could likely mean huge results for me in the long run. Peter Renton at Lend Academy is another serious investor who has publicly stated that “he is no longer adding new money to taxable accounts” because the benefits of an IRA are so huge.
Read more: Retire Well with a Lending Club IRA.
Two More Complicated Ways to Increase ROI
For those who are interested in spending a bit more time on this investment, there are a few extra things that you can do to potentially bump up your returns. Keep in mind that both of these mean a more active investment. I personally avoid them because I prefer my investments to be as passive as possible.
#6: Explore filtering more deeply
Earlier we showed that the simple filter of Inquiries = 0 is a great way to a increase your returns. However, this is a complex subject that can actually offer great potential to those willing to explore it more fully. A good introduction is my latest post on filtering. You can also read my eBook (15 pages about filtering) or watch my video series on it.
In essence, filtering is a form of arbitrage. It means we find weaknesses in Lending Club’s assigned interest rates, and then exploit these mispricings to increase our overall return. The most effective way to exploit this mispricing is actually not with simple filtering, but by creating your own pricing model/algorithm, using it to discover Lending Club’s mispricing on a holistic level. However, creating a custom algorithm is beyond the ability of 99% of investors. To help, sites like BlueVestment allow investments through an independent credit model, so you may want to check them out.
I personally earn a return of around 10% per year in peer to peer lending (see my returns). While the main driver behind this higher-than-normal return is the higher risk I take on, I feel a second reason is the (non-algorithm) filtering that I’ve been doing ever since I began.
#7: Buy and/or sell loans on the Foliofn secondary market
Peer to peer investments have been classified by the SEC as a security. Not only does this mean we have great regulatory oversight on our investment, but we also have the ability to buy and sell loans on a secondary market. Lending Club’s secondary market (operated through Foliofn) is actually really huge, with over 100,000 loans commonly available for purchase:
This marketplace is sort of a huge Wild West in peer to peer lending.
This marketplace is sort of a huge Wild West in peer to peer lending. Investors have the potential to earn a lot if they understand it, but they also can lose their shirt. This is because, on the whole, Foliofn is far more complicated than the simple Browse Notes area of the primary market, and its website can feel somewhat clumsy. Overall, it is a bit speculative.
Selling issued loans: One strategy people have used, including myself, is to sell notes on Foliofn that have gone late. Sometimes there is a marginal benefit to actively selling your late loans at a discount instead of passively waiting for them to default. You can read more in my article: How to Sell Your Late Loans. However, people have stated this strategy does not work as well as it used to.
Buying issued loans: Another strategy people employ is buying notes on the Foliofn secondary market. For some investors, like those in Texas, the primary market is not available, so Foliofn is the only p2p investing open to them. The good news is many have earned great returns here as long as they try to keep things simple and stick to the traditional maxim of spreading their investment equally across 200+ notes. Since many people are selling loans on Foliofn in order to liquidate and close their Lending Club accounts, there is an opportunity to find some great deals.
An interesting strategy is NewJerseyGuy’s approach, which he has actually written about in a guest post on PeerSocialLending.
I am not that experienced in actively buying/selling notes on the secondary market. The primary market works great for what I need from it (great passive yield). That said, I personally know investors who regularly earn over 20% per year by getting really involved on Foliofn. However, these are incredibly smart and talented people who have taken lots of time to learn the ins and outs of this Wild West economy. If this sounds appealing to you, the Lend Academy forum is probably your best bet for a starting place.
A Final Simple Strategy: Stay Updated
Peer to peer lending is still in its infancy. Even though Lending Club has been around since 2007, they are just gaining traction as a company. It took them five years to issue their first billion dollars in loans. Today they are issuing this amount every three months!
As a result, this avenue of investment will almost certainly experience some major changes that will impact retail investors like you and me. It is probably a good idea to subscribe to the LendingMemo newsletter and keep tabs on what’s happening. While the future of p2p lending is unknown, the changes will take us less by surprise if we remain active in the conversation.
[image credit: Stefan Erschwendner “Strategy” CC-BY 2.0]