I logged into my Lending Club account the other day and was met with an unfortunate reality–I’m an underachiever. My current rate of return is 7.43%, while the average rate of return is 9.67%. Lending Club was even kind enough to provide a bar chart to showcase my less than stellar performance:
My first reaction was to hypothesize that the number of Lending Club notes I own (about 45) was too few to draw any statistically valid conclusions. While there may be some truth to that, Lending Club also compared my returns with those who have invested in a similar number and amount of notes. And I’m still falling short, with the average of this group coming in at 8.23%.
So I spent some time on Lending Club and devised a strategy to improve my returns. There are no guarantees that it will work, of course, but I’m confident enough in the approach to share it with you. And the nice thing is that the strategy is extremely easy to execute. So here it is.
How to Boost Your Returns on Lending Club
The strategy involves buying Lending Club notes on the secondary market. So rather than investing in a new loan, invest in an existing loan that has been put up for sale by the original investor. Let me explain why I’m taking this approach, and then we’ll turn to how I’m picking the notes I’m buying.
The interest rates on Lending Club notes are determined based on the credit worthiness of the borrower. Lending Club uses a formula that takes into account, among other things, the borrower’s credit score, debt-to-income ratio, loan amount, loan term, and prevailing interest rates. Based on these and other factors, Lending Club assigns a grade to each borrower that ranges from A1 to G5. As the prevailing interest rates rise and fall, the rate Lending Club charges also goes up and down for each of its credit grades. As a result, when you invest in a new note, the interest rate you’ll earn is whatever is assigned to the credit grade of the note, less fees.
Buying a note on the secondary market is very different. Rather than earning the prevailing interest rate, you’ll earn whatever rate was assigned to the loan when it was issued. That rate could be higher or lower than today’s rate. That’s important, and we’ll return to this fluctuation in rates in just moment.
When you invest in a new Lending Club note, you lock up your money for either three or five years, depending on the term of the note. So what do you do if you need the money before the loan matures? You sell it on Lending Club’s secondary market. But what if you can’t find a buyer? Well, you do the same thing people do when they can’t sell real estate—you lower the price. As a result, you can find notes on the secondary market that are selling for less than the face value.
So combining the fluctuation in interest rates with a lender’s desire to sell a note at a discount can result in a really good deal for investors. So now let’s look at how I’m picking the loans to buy.
How to Pick a Loan on Lending Club’s Secondary Market
The easiest way to explain how I choose notes is step-by-step:
Step 1: Only pick notes that are current: You’ll see plenty of loans on Lending Club’s secondary market that are in default or late. I avoid these loans because of the increased risk of loss of principal. That’s not to say these loans are necessarily bad investments. At the right price, they may be great investments. But because investors have no control over the collection process, the risk is just more than I want to entertain.
Step 1a: Once you find notes that are current, you need to look at the payment history on the note: What you may find is that while the note is current, the borrower has a history of paying late. I stay away from these notes for the same reason I’m looking for a current note in the first place. If they have been paying on the loan for say a year and have been late once, that might be ok. But you’ll find some loans in which the borrower is late nine times out of 10. Those are the notes to avoid.
Step 2: Only pick notes where the borrower’s credit has stayed the same or gone up: When you browse notes for sale, one piece of information available to you is whether the borrower’s credit score has gone down, up, or stayed the same. I avoid borrowers whose credit score has declined. Again, at the right price these loans may be excellent investments, but I don’t need the added risk. P2P loans are risky enough.
Step 3: Only pick notes selling at a discount (while keeping an eye on interest rates): I look for notes that are selling at a discount off of the current principal balance. So if a loan is for sale with a principal balance of say $20, I’m only interested if the lender is selling the note for less than $20. I’ve generally found notes that meet criteria 1 and 2 above at a discount of 3% to 5%. And that’s huge when you think that prevailing rates on a savings account are about 1%.
But there’s a catch. You need to compare the interest rate on the loan with the prevailing rates for a new loan with the same credit grade. For example, if I’m looking at a loan with a credit grade of C3 and an interest rate of 13.5%, I want to make sure I can’t invest in a new C3 loan for say 15%. If I can, I need to factor in that interest rate spread with the discount being offered. Generally, however, I’m finding notes that are not only selling at a discount, but also have slightly higher interest rates than what I can find on a new loan with the same credit grade. I call that a win-win.
One final tip—look for low credit grade loans where the borrower has a history of on-time payments. When buying new loans, I tend to stay away from the lower credit grades. While they offer higher rates, the risk is just too much for my taste. But on the secondary market, you can find aged loans with low credit grades and a history of timely payments. To me that’s one of the best loans to buy. It’s not without risk, of course, but the rates and discount price make it with the risk (at least for me).
As I mentioned at the start, I’ve just started following this approach. Once I see how the loans perform, I’ll write an update to let you know how things are progressing.
If you’d like to get a loan or invest in Lending Club notes, visit Lending Club for more information.
And here are some additional resources I’ve found where other folks describe their experience buying Lending Club notes on the secondary market: