One of my clients - a woman who was laid off during the recession and has transitioned into a very promising second career - came to me recently to discuss ways to increase her yield. A decade away from retirement with a net worth of about $3 million, she felt she could take on a bit more risk on the fixed-income side of her IRA.
The solution we turned to was peer-to-peer lending, a web-enabled model that connects individual lenders and borrowers. Using a couple of new lending websites, we created a laddered portfolio, composed of 20 individual loans, that's produced a return that's made her quite happy.
What's attractive about peer-to-peer (often called P2P) lending is that it's a winner for both funder and recipient. Borrowers pay less interest than they would for a conventional bank loan and lenders, by taking on more risk, get higher returns than they would find elsewhere in the fixed-income market.
I've been a marketplace lender for more than two years, and my most recent statement shows a 7.94% return. In a low-yield environment, P2P lending with proper due diligence can be a way to boost yield, help people and celebrate the free markets.
There are now about 50 P2P lending platforms worldwide, according to Disruption Credit, an investment firm that earlier this year launched a fund of P2P loans. I tend to focus on two major players: the first entrant, Prosper Marketplace, and Lending Club, the largest firm in an increasingly competitive field.
Founded in 2006, Prosper Marketplace's members have invested more than $690 million to date. It has raised $120 million in venture capital, according to Crunchbase, and is backed by several finance and technology heavy hitters.
Lending Club was launched in 2007; as of early January, it reports having funded loans worth $3.259 billion - lending $241 million in December alone. Lending Club also says it has paid investors almost $296 million in interest since its inception. Additional information, including current SEC filings, is posted on the two companies' websites. (Because all P2P loans are securities registered with the SEC, quarterly and annual financial reports must be filed with the agency.)
WHO CAN BORROW?
Clients might think of these P2P sites as online clearinghouses for anyone looking for cash. But prospective borrowers are pre-screened for their creditworthiness. Prosper requires a credit score of 640 or more and Lending Club requires a score of 660 or more, approving fewer than 10% of loan requests. Loan amounts are restricted to less than $35,000.
Naturally, credit risk determines how the approved loans are graded and the corresponding interest rates. Prosper rates loans AA through high risk, and estimates the potential for a loss based on historical data. Lending Club rates loans A to G, and assigns interest rates ranging from 7.39% to 23.48%, which include the company's fee.
One of my loans supports a veteran just out of the Navy. He receives a monthly stipend of $2,000 as part of the GI Bill to further his education. He's studying to become a nurse while supporting a family of four. When he applied for a small loan to add a room onto his house, the bank denied him because they would not factor the government's stipend into his income.
His $5,000 loan request was one of the first few I made and he's never missed a payment. I got a great return, plus the satisfaction of helping someone who faithfully served our country.
Interestingly, P2P lending companies have standards for lenders, too. In fact, a lender must have either an income of $70,000 a year or a net worth of $250,000. Some of the states where Prosper and Lending Club operate also have additional requirements.
Since retail and institutional lenders alike are permitted to invest as little as $25 in each loan they choose, the marketplace encourages risk-tempering diversification. For example, I invested $10,000 in 25 different loans. Some people invest $1,000 across 10 different loans.
It's important to mix up a P2P portfolio. You could vary your loan quality the same way a fixed-income portfolio might, ranging from high-grade to junk. (I prefer to stay with investment-grade loans; the 25 loans I've made range from AA to AAA ratings.) Or you can choose loans with different maturities, the same way you would construct a bond or CD ladder.
Overall, I recommend clients control risk by staying with investment-grade loans, favoring shorter durations and diversifying across a number of separate loans. The latter helps guard against the risk that a single borrower will default and cause you to lose everything.
One key difference from junk bond defaults: Even if a delinquent P2P borrower eventually pays up through a collections process, lenders won't get the full amount they are owed. The Lending Club's prospectus, for instance, cautions: "If collection action must be taken in respect of a member loan, we or the collection agency may charge a collection fee of between 30% and 35% of any amounts that are obtained. These fees will correspondingly reduce the amounts of any payments you receive." Prosper cites lower collection fees of 17% to 30%.
ADVICE FOR CLIENTS
A recent Natixis Global Asset Management Global Investor Insights Survey found that a majority of investors do not believe the traditional equities/bond portfolio allocation can meet their goals. These investors are often looking for alternatives other than hedge funds, private equity or venture capital funds.
I find many clients are thankful for the potential to increase yield on the fixed-income side of their portfolio. When presenting P2P lending to clients, however, it's important to carefully articulate the potential risks and rewards - as with any investment. Our firm also has emphasized that, in accordance with our diversification policy, no more than 5% to 10% of a portfolio should ever be invested in any one vehicle.
Make sure your clients are comfortable with the long term strategy. The illiquid nature of P2P loans makes them well suited to retirement accounts, where clients tend to have a longer-term perspective. For clients whose income prevents them from opening a Roth IRA or a deductible IRA, a nondeductible IRA will also work. Invested there, interest paid grows tax-deferred rather than being taxed at the investor's ordinary income tax rate.
Moreover, for individuals with $200,000 of adjusted gross income or married couples with $250,000 in adjusted gross income, the tax-advantaged IRA account can also help them escape the new 3.8% Medicare surtax on investment income mandated by the Affordable Care Act.
P2P loans seem tailor-made for our prolonged low-interest-rate environment, where banks continue to hoard their cash and credit remains tight. However, even if interest rates increase, money will continue to flow to where it is rewarded.
Kimberly Foss, CFP, CPWA, is founder and president of Empyrion Wealth Management in Roseville, Calif.