It’s probably pretty obvious to visitors of this site that I’m a fan of lending money online. A significant portion of my week is dedicated to reading, writing, and having conversations about p2p lending. I’m so convinced, I’ve even suggested investors put 20% of their excess cash into this investment.
That said, a number of problems remain. Peer to peer lending continues to be a niche investment in the US. Despite millions of people actively saving for retirement in stocks and bonds, only a tiny fraction invest in consumer loans.
Even the Cunninghams Aren’t Doing It
This problem is best illustrated by my own family situation. Neither my parents, siblings, nor in-laws are investing in peer to peer loans. You would think having a peer to peer nerd as a son/brother would make it happen. Yet years later, I am the only one in the group who is involved.
Here’s the thing: my family is awesome. They are a bunch of smart, generous, fun-loving crazies who are up for anything, including novel ways to make money. For example, as a family we planted thousands of pine saplings in our backyard to sell later as Christmas trees. We bought them for 10 cents, eventually selling them for $50 each. Talk about a great investment.
If the Cunninghams aren’t getting involved, something else must be going on. My hunch is that their reasons are typical for millions of other Americans nationwide. As a result, I phoned ’em up and asked them about it.
7 Problems that Stop People from Lending Money Online
My family gave me a lot of food for thought. Combined with other opinions in the industry, here are the biggest reasons why people aren’t involved in peer to peer lending.
Biggest issue: Many Americans don’t invest at all
There is a coming crisis headed for our country. Fifty percent of Americans say they can’t afford to save for retirement, much less invest at Lending Club or Prosper. In fact, the anxiety people feel around retirement is greater than any other financial problem they have, including sending their kids to college or paying for housing. (see Gallup). Thankfully, my family is not in this category.
If you aren’t saving anything for retirement, you need to stop reading this article. Call in sick to work, draw the blinds, and watch The Retirement Gamble by PBS.
Issue #2: Peer to peer lending is a self-directed investment with a learning curve
The biggest roadblock cited by my family? You have to do it yourself.
Most Americans don’t fix their own cars or tend to their own medical issues, so why should people have to manage their own financial portfolios? Instead, my family just has their employers manage their retirement so that they can focus on other things. And the truth is, most Americans do that too — investing through third-parties like an employer’s 401k. More often than not, this works fine (though most end up paying over $150,000 in fees).
Peer to peer lending has gotten simpler over the years (e.g.: Prosper ending their auction system). However, it still remains pretty complicated for the average Joe. The main complicators: choosing loan grades and diversifying in 200+ notes.
- Choosing loan grades – A new investor needs time and patience to understand what ‘grades’ are, self-assessing their own tolerance of losing money to bad loans (see: What Grades Should I Choose?).
- Diversifying in enough notes – A new investor needs time and patience to understand what a ‘note’ is, and how spreading cash across hundreds of these notes keeps things more predictable (see: Diversifying your Account).
This problem is most obvious by looking at Lending Club and Prosper’s websites. Both require people to manually select their own loan grades while also needing them to manually diversify across enough notes. Can you feel the new investors getting overwhelmed? This stuff is just too heady for most people.
Eventually, these loans will be a part of funds that financial groups can allocate into employer plans and 401(k)s. But for now, p2p lending appeals to the self-directed.
Issue #3: Many states do not allow peer to peer lending
My family is from Michigan, which is closed to Lending Club (though open to Prosper). They are not alone in their limitation. A large portion of our national population lives in states that do not allow peer to peer lending at all (e.g., Ohio and Texas). The financial regulators in these states have deemed this investment as too risky, so millions of people have no access.
Thankfully, Lending Club’s IPO should open up more states with time (through a Blue Sky exemption). But for now, half the nation can’t even open an account. See: What States are Open to Lending Club & Prosper?
Issue #4: The minimum investment is too much money
When I first began peer to peer lending in 2011, I opened up a Lending Club account with just $1000 in 40 $25 notes. I wasn’t diversified at all. This is because a $1,000 trial investment was all I could spare, and looking back you can see diversifying across just 40 notes was like playing with fire. Thankfully, I had a positive experience.
For most though, the fact remains that a $2,000 trial investment at Lending Club or Prosper is just too steep. Most people don’t try anything with $2,000. What parent gives their middle schooler a $2,000 saxophone on the first day of band class?
Issue #5: The returns are not as good as the stock market
Most people are interested in long-term investments, and over time this investment is easily beat out by the stock market.
Above you can see every 3-year loan issued since Lending Club gained approval from the SEC in 2009. To the right I’ve listed the much larger average return of the S&P500 index (source). 75 years of stock market earnings easily outshine Lending Club’s past six years of issued loans.
Peer to peer lending’s current 7% return, while notable and consistent, is not really a headline-maker. If it had instead returned something like 10% per year to all its investors, there would be greater popular buy-in. For now, the stock market remains the king of returns.
Issue #6: The 1% investor fee is not exceptional
New investors might be interested to hear I’ve taken a $20,000 investment and earned $6,800 in interest over the past few years. But fewer are aware that I’ve paid $184 to Lending Club in fees, 1% per year.
Vanguard has fees as low as 0.05% per year, a twentieth of Lending Club’s cost.
In contrast, investments in stocks and bonds through a company like Vanguard commonly have fees as low as 0.05% per year, a twentieth of Lending Club’s cost. The reason they can do this is because Vanguard’s funds are so popular. The massive number of investors means every person pays a smaller share of the costs.
That said, the central reason why Lending Club and Prosper are doing so well is because they operate completely online. Without branches or tellers like a bank, their cost of business is a fraction of a traditional lender. However, investors like myself have not experienced this benefit in the form of lower fees. Compared to other investments throughout the country, peer to peer lending is not much cheaper to do, another non-incentive for America’s money managers.
Issue #7: Taxes at Lending Club and Prosper can be a burden
Taxes can be expensive: Investing in the stock market is so deeply woven into the fabric of the United States that it gets its own special tax rate: just 15%. By comparison, investing at Lending Club or Prosper has the same tax rate as interest earned from something like a savings account. If you’re in the 30% tax bracket, you will lose 30% of your p2p earnings to taxes. Of course, you can lessen this issue with a tax-incentivized IRA, but most don’t do this.
Taxes can be confusing: Defaulted principal is typically classified as capital losses while recovered principal is seen as capital gains. Further, the paperwork can be tedious if you’re active on the Foliofn secondary market (though most are not).
P2P Lending is Still a Remarkable Investment
Yes, there’s a learning curve. And yes, this investment doesn’t earn a higher return than the stock market. However, it still offers some incredible benefits:
- Typically earns 5-9% and has never had a negative year
- The chance to diversify your savings across another asset class (perfect compliment to stocks and bonds)
- A passive investment (via automated tools)
- A meaningful way to invest that sets borrowers free from debt
Read about these benefits in-depth here: What is Peer to Peer Lending?
I finally got my parents to open an account
While talking to my dad about this article, he realized he has a small IRA that he opened in the 80s, but which hasn’t been touched in decades. There isn’t much money in it, so he thought, “This is a perfect little lump sum for a trial investment. Why don’t we move it into peer to peer loans so I can see what all this fuss is about?”
What do you think? Are there any problems I missed?
[image credit: ‘beacon‘ by Mitchell Haindfield CC-BY 2.0]