When I was in college, one of my professors used the following example to explain financial diversification. When the weather is sunny and beautiful, people are more likely to buy ice cream cones to enjoy as they walk about the town. But on days where the weather is cloudy and rainy, the store selling umbrellas will have more sales than the ice cream shop next door.
Despite the fact that both stores’ profits will fluctuate from day to day and season to season, it’s not inconceivable that the two businesses could generate similar revenues over the course of a year.
If you had invested all of your money in the ice cream shop, those rainy days would seem even gloomier. And sunny days would be especially nerve-wracking if your life savings were invested in the umbrella shop. But if you had a stake in both enterprises, each day might feel a little bit sunnier, financially speaking, no matter the actual weather conditions.
This illustration exemplifies why you’ve always been advised to hold a mixture of stocks, bonds, and real estate. That’s because different asset classes respond to market pressures in their own ways.
Over the past ten years, another layer of insulation has emerged to help investors further diversify their holdings. Peer-to-peer lending offers investors a unique amount of control and diversification not found in other asset classes.
LendingClub is one of the most recognizable peer-to-peer lending platforms on the market. It’s not only a useful source of credit for borrowers, but it can also help investors gain exposure to a unique segment of the market.
In this review, we’ll examine LendingClub’s offerings from an investor perspective (rather than borrower), so you can decide if LendingClub’s peer-to-peer loans deserve a place in your investment portfolio.
What is LendingClub?
Formed in 2006, LendingClub has established itself as an industry leader in the peer-to-peer lending space. LendingClub has gained recognition because of its straightforward investing process, low barriers to entry, and a state-of-the-art app experience.
LendingClub has become a viable alternative investment for individuals looking to diversify their portfolio by accessing an asset class traditionally available only to major financial institutions. This is made possible through one of LendingClub’s most unique features – that is, investors, not banks, are the primary funding source of consumer loans offered through the platform.
In 2014, LendingClub went public, become the first peer-to-peer lending institution to do so. As of publication, LendingClub has serviced over $16 billion in peer-to-peer loans and has gathered funding from over 188,000 individual investors.
Borrowing Money with LendingClub
Before we get into the nitty-gritty investing details, let’s start with a quick overview of how LendingClub’s program works for borrowers.
According to LendingClub, most prospective borrower applications are denied. This is due in large part to the strict criteria that LendingClub uses to carefully screen borrowers. At a minimum, applicants must have a credit score of at least 660. Other elaborate underwriting guidelines mean that only a small subset of borrowers qualify, which serves to protect investor funds.
LendingClub offers a variety of loan types, including loans for small businesses, debt consolidation (e.g., refinancing auto, medical, and credit card debt), home improvement projects, and more.
The most popular type of loans offered on the platform are personal loans. These loans range from $1,000 to $40,000 and cost between 6% and 36% APR (depending on certain underwriting criteria) and carry an average interest rate of 14% APR.
How Does Investing with LendingClub Work?
As a LendingClub investor, you purchase what LendingClub calls “Notes.” Rather than making a loan directly to a borrower, you are obtaining a fractional interest in separate loans. Simply put, each Note is a separate investment in a consumer loan that has its own unique characteristics. As borrowers repay their loans, LendingClub will deposit your cut of each payment (based on your interest in the Note) into your account.
The small dollar amount you can invest in a single Note is $25. Consequently, the more you invest, the more diversity your portfolio will achieve. According to LendingClub’s data, investors holding 100 or more Notes in their portfolio have a 99% chance of seeing positive returns on their overall portfolio.
The average interest rate collected on a Note is 14%. Of course, the interest rate will vary from one investor to the next depending on their investment strategies and the loans they fund. LendingClub estimates that the average investor’s yield is reduced by approximately 8% due to charge-offs and prepayments. And when you factor in LendingClub’s 1% annual fee, you’re left with an annualized net return of roughly 5% before taxes. This is in line with LendingClub’s reported historical net returns of 3-8%.
New Notes are added four times a day, at four-hour intervals, starting at 6 AM Pacific Time. Some describe these periodic influxes of new Notes as feeding frenzies where the sharks of LendingClub devour top Notes almost instantaneously. That might be a bit dramatic, but you should probably log on during those timeframes to increase your chances of acquiring an interest in optimal Notes.
Who Can Invest with LendingClub?
Not only does LendingClub maintain stringent borrower requirements, but it also has certain requirements in place for investors too.
- State Eligibility. LendingClub is available to investors in all states except Alaska, New Mexico, North Carolina, Ohio and Pennsylvania.
- Initial Deposit. First things first, you’ll need to be prepared to meet the minimum initial deposit requirement of at least $1,000.
- Annual Income. In most states, investors must have an annual income of at least $70k and a net worth of at least $70k to qualify. In California, investors must have an annual income of at least $85k and a net worth of at least $85k.
- Net Worth. The annual income requirements are waived for any investor with a net worth of greater than $250k ($200k in California).
LendingClub Investing Options
LendingClub offers a couple investing modes. You can either invest manually or opt for an automated approach.
Much like shopping for a car online, LendingClub allows investors to customize their investment criteria so they can refine their search results and target Notes with specific characteristics. LendingClub’s investment criteria includes the following factors:
- Interest Rate
- Loan Term
- Loan Purpose
- FICO Score
- Recent Delinquencies
- Monthly Income
- Debt-to-Income Ratio
Investing manually certainly comes at a cost. While you’ll have more control over the Notes you select, it will take time to analyze individual loans and build up your portfolio. Still, there is something enjoyable about handpicking Notes that best fit your guidelines. After all, your goal is to hold the Note for the life of the loan, so why not be the person who evaluates the Notes you’re purchasing?
The alternative method for purchasing Notes is through automated investing. With automated investing, LendingClub will automate purchases of Notes based on your exact specifications.
The primary goal of automated investing is to keep your cash invested and working for you. Since $25 is the minimum investment per Note, LendingClub will purchase new Notes any time your cash balance reaches $25 and a Note satisfies the criteria you’ve selected. You can turn automated investing on or off at any time and you can still place manual orders even if your account is set to invest automatically.
LendingClub Investing Risks
There are numerous examples of unsystematic risks associated with peer-to-peer lending investments. Here are four risks you should consider before jumping in and investing with LendingClub.
- Unfavorable Tax Treatment. When you make money investing with LendingClub, the returns are automatically realized. Therefore, if you elect for the typical taxable account your full yield is taxed just like your income. For example, if you are in the 22% tax bracket, your 5% yield shrinks to 4%. In the LendingClub system, only those in above average tax brackets can invest. That makes taxation rough for all users. Also, due to the monthly returns, your investments aren’t like stocks where you can hold them longer waiting for a more favorable tax event.
- Tax Protected Accounts aren’t Ideal. The logical response to the taxation problem is to open a tax-sheltered account with LendingClub. What’s the drawback? If your IRA is being used for retirement income, then there are more optimal long-term investing products. Furthermore, it would likely take about 3 years’ of maxing out your IRA before I’d consider your notes sufficiently diversified.
- Loans are not Secured. This is the nature of the LendingClub model, but it’s scary that there is no asset to collect against in a borrower defaults. Therefore, you really have to think critically when you analyze how you go about selecting notes. While you can filter applicants by criteria associated with creditworthiness, you’re still playing a guessing game to select borrowers who will repay their loan to protect their FICO score.
- Notes are not Liquid. “Sell when there is something better to buy” is a phrase used when discussing stock ownership, but it doesn’t apply to peer-to-peer loans. With LendingClub, the notes you own are not liquid assets like stocks. When you become frustrated with a Note’s performance, you can’t simply liquidate your stake in the investment instantaneously.
Because the US government doesn’t consider LendingClub investments to be “passive,” any profits will be treated as ordinary income and taxed at your marginal tax rate. That means you won’t be able to take advantage of a more favorable long-term capital gains tax rate. That makes taxable accounts a frustratingly inefficient option for investors.
Alternatively, LendingClub offers IRA investment accounts, which would be far more tax efficient than taxable accounts. LendingClub requires a minimum deposit of $5,000 to open a no-fee IRA for year one. To avoid fees during the second year, you’ll need to increase your balance to at least $10,000. Although a LendingClub self-directed IRA is certainly more tax efficient than a standard taxable account, that doesn’t necessarily mean I’d recommend that option. I prefer to hold higher upside assets in my tax-advantaged accounts to maximize favorable tax treatment. LendingClub’s historical returns don’t suggest that there’s enough upside to justify holding LendingClub Notes in an IRA.
United Airlines Promotion
LendingClub partnered with United Airlines to offer an incentive for potential investors. This offer is available only to new investors who open a taxable account. Here’s how it works: As an investor you can receive 1 mile per dollar invested, up to 40,000 miles.
It will take at least 20-35k miles to unlock a basic domestic flight, which requires a sizeable investment to earn those bonus miles. Depending on your personal situation, this might be more exposure to peer-to-peer loans than you care for. Obviously, you shouldn’t overextend yourself for the sake of racking up a few more bonus miles toward a flight. But if you were already planning to invest with LendingClub, this promotion is a nice cherry on top.
Potential for Higher Returns. Investors with higher risk appetites can cash in on higher returns than they’ll find with most other traditional investments.
- Automated Investing Options. For investors who prefer a less hands-on approach, LendingClub offers tools that can automate investments on the platform for you.
- Low Per-Note Investment Requirement Makes Diversifying Easier. $25 Note minimums mean you can easily diversify your portfolio by purchasing Notes that correspond with different loans and borrowers.
- Sophisticated Search Filters. LendingClub’s filtering options make it easy to find the notes you want to invest in.
- Low Initial Deposit. You only need $1,000 to start investing with LendingClub.
1% Annual Fee. You’ll pay a 1% annual fee for each Note you own within the LendingClub marketplace.
- Debts are Unsecured. Debts are not collateralized by assets to guard against default.
- Modest Investment Returns. LendingClub’s historical returns are between 3-8% per year.
- Earnings Taxed as Ordinary Income. Unfavorable tax treatment takes a major bite out of your returns.
- Limited Data on Historic Returns. On top of the limited data on peer-to-peer loans as an investment, LendingClub’s platform has not been tested by an economic recession.
Is LendingClub Right for You?
LendingClub has arguably become the top dog in the peer-to-peer lending space, drawing the attention of both borrowers and investors across the country.
With relatively low barriers to entry and an opportunity for solid returns, LendingClub’s peer-to-peer lending service has some attractive features that experienced investors may want to add to their portfolios. I inherently like the potential that comes with adding a new asset class to my portfolio, because of the likelihood LendingClub Notes will perform differently than most stocks and bonds. Plus, the potential to get decent returns in the process makes it even more appealing.
However, investing with LendingClub isn’t without its risks. Unsecured debt charge-offs will always be an adversarial leach, draining your overall returns. Another drawback is the need for consistent maintenance when manually selecting Notes, as this process is more rigorous and time-intensive than what you’ll experience when selecting a mutual fund. And if you’re in a higher tax bracket, you’ll definitely feel the sting when your gains are taxed at ordinary income rates.
While there are certainly investments that offer similar returns for less effort, LendingClub does have some attractive elements. If you’re looking for exposure to a new asset class and don’t mind doing the legwork to choose Notes to invest in, LendingClub might be an investing option worth considering.