Guest post: How peer lending fits into my portfolio

I’ve frequently stated that I need to overhaul my portfolio. Currently, I hold almost everything in aggressive stock funds or even pure stocks. While this strategy may be a bit reckless, I’m not fond of the idea of losing money to inflation when holding it in cash or bonds.

I was chatting with Write Your Own Reality (Mr. WYOR from this point on) about this topic recently. Mr. WYOR has a clever solution to my dilemma. It revolves around something that I like very much and that I’ve believed in for a long time; peer lending. I like Mr. WYOR’s solution so much that I plan to fully implement it before I retire. His solution will allow me to do two things:

• Emergency fund: If I run into a rough patch, I’ll be able to tap my peer lending account for 3 years of living expenses.
• Buy low, sell high: I want to be able to take advantage of different economic situations in retirement. For example, in times like now where market valuations are historically high, I don’t mind selling investments to fund my existence. However, the thought of selling the same investments in a bear market where valuations are below average is painful. In a low valuation environment, I’d rather live off cash or peer lending as you shall see.

Please welcome Mr. WYOR everyone!

Using P2P Lending to Protect Against Short-Term Cash Needs

One of the harder decisions once you’ve retired or reached FI is determining the amount of cash one needs on hand. Why is this important? For many folks, funding retirement is a matter of withdrawing 3-4% of their portfolio balance each year to support their retirement lifestyle. By having some substantial cash on hand, you can better control your withdrawals and generally sell on your terms. Of course, figuring out how much of a cash buffer you might need in order to protect yourself is complicated. You want enough to have enough cash to be prepared to cover unexpected needs, but you don’t want so much that you’re forfeiting the amount of money you have working for you in the markets or elsewhere.

It is at this point P2P Lending (becoming more known as Marketplace Lending) can come into play. Imagine a scenario where you keep between 6-12 months worth of living expenses in cash. You continue to sell your investments as needed to maintain your liquidity, however, should the markets tank, you’ve built an extended cash provider that can turn into immediate cash on an on-going basis for three years. This provider is P2P Lending. Structured well, it can be the three-year job you don’t need to take when the markets struggle.

Mr. 1500 note: If you’re unfamiliar with P2P lending, please check out Mr. WYOR’s posts on Lending Club and Prosper.

Creating a Reserve Fund with P2P Lending

First, let’s look at the basic mechanics of Lending Club and Prosper notes and how one might structure this arrangement. With Lending Club and Prosper, you have two primary options, 36 and 60-month loans. While you tend to earn a premium for investing in five year notes, for someone looking to utilize this option for potential cash flow protection, sticking with the 36-month notes will be better. Why is this? With 36-month notes, you will receive payments of principle and interest approximately 50% higher than with 60-month notes.

For a $100,000 invested amount, this is over $1,000 per month of additional cash. This is we call a material difference in the world of accounting, but in your life, it can be even more significant. Just think about being in a situation where you are relying on the cash flow from your investments. Would $2,000 or $3,000 per month work out better for you? I’d imagine it would be the latter.

Great, so we’ve decided that for cash flow reasons 36-month notes are ideal. Now we have to look at risk tolerance and expected returns as this dictates both the sustainability and the downside should the economic climate change.

Risk, as with any investment, is important. Risk ultimately determines the premium one is paid for investing in a certain manner. Government bonds versus junk bonds. There can be more than a 10% difference in the yield almost solely due to risk. With peer to peer lending, risk takes a couple of forms, but the primary risk is whether or not the borrowers will default on their obligation. Below is a chart of returns and associated defaults of 36-month loans as provided by Nickel Steamroller, a third-party site that tracks P2P Lending statistics. Due to delays in the release of historic information by Lending Club, this information contains notes issued prior to September 30, 2014.

Note: All filtering and metrics are done with equally weighted loans. Unless you’re a big enough investor to purchase whole loans, you will be parsing out your investment with a fixed denomination. Skipping this presentation can alter your filtering research as large notes performance will disproportionately impact the overall return.

As you can see, while the return on investment (ROI) generally goes up as the loan grade gets lower, the default percentage increases tremendously. While we could get into some of the specifics of this, that would require a more detailed post that is ancillary to what we’re focused on today.

What we want to narrow in on is limiting the risk for a portfolio that is ultimately going to be your extended emergency fund. Instead of holding 2-3 years in cash, we are replacing most of that to earn a higher interest rate than a traditionally savings account, while being in a fairly controlled environment. As such, our focus will be on the highest two loan grades, A and B. These two have the lowest level of defaults and often these borrowers are truly prime candidates with excellent credit histories.

Without any filtering, all A and B loans have combined to earn a net of 6.49%, net of the transaction fees and 3.04% of defaults (image above). In order to properly leverage this methodology, one would want to further decrease the number of defaults as a hedge against a downturn in the economy. As an investor in the lowest-risk borrowers, you’ve already put yourself in a solid position as these will be the least likely folks to see an increase in defaults. However, an increase will occur, so minimizing your risk upfront, will allow you to weather any storm and preserve your capital.

Implementing just three simple filters, above and beyond the loan grade, will drastically change the default ratio, which should protect your investment should trouble strike. The three filters are:

• Loan Type: Credit Card Refinance and Debt Consolidation
• Inquiries Last Six Months: Zero
• Monthly Income: Greater than $5,500

Sure we could filter further and continually reduce the default rate and increase the projected return on investment; however, when maintaining a larger portfolio you have to worry about the ability to scale upwards. If your filter is too restrictive, finding notes in a timely fashion can and will be difficult. A great example of this is borrower income.

Borrower income is generally a solid indicator of future performance, with the higher the better. However, even just changing $500 per month going from $5,000 to $5,500 eliminated over 8,000 loans from the history. Increasing the monthly income requirement even further to $6,000 per month results in an additional 5,000 loans being eliminated from the loan history, or in other words almost 30% of the loans issued that fall under the above filters. I’ve picked the middle point as it generates more impact historically that going that one step higher while still allowing for a reasonable volume of notes.

With the aforementioned filters, we’ve taken our original projected return of 6.49% and increased it to 7.42%, while lowering the anticipated default rate of 3.04% to 1.75%. This is a decline of 42.4% in defaults, a substantial margin. You can see in the image below the historic returns as a result of the filtering. Also note the number of loans that meet this criteria, 37,039, versus that of the unfiltered results of 166,134.

Now is probably a good time to remind everyone that historic returns are not a guarantee of future results. Due diligence is a must with any investment, as is managing expectations.

So we understand the investment criteria and the term of notes, now what? Let’s make some base level of assumptions for the anticipated return and see how this impacts the potential cash flow at any given balance.

Kickin’ Cash Out Like a Boss

By maintaining your reserve cash in P2P Lending, you’ve created an opportunity for that money to continue to grow and build beyond what it might do sitting in a savings account. However, given the 3 year nature of the investment, you aren’t going to be able to pull out all of your cash immediately. While this might seem like a problem, a 36-month amortizing loan can provide a great amount of cash flow in a short period of time.

Each month, you receive payments that consist of both principal and interest. These payments, unless needed, can be reinvested, therefore compounding your money to offset inflation and provide long-term upside as cash needs increase. Should you need the cash, simply stop reinvesting and begin taking draws, as if you had a short-term pension.

With 36-month notes, an investor will receive approximately 35-37% of their invested balance per year at the point you stop reinvesting the cash. While this percentage will vary based on the average interest rate earned by your portfolio, this is pretty close to what you can expect given the parameters laid out above. With the historic return reflected above, you’d actually be above the 37% mark.

In the table below, you can see the projected annual cash flows for $100,000 invested, assuming that you need to pull out cash right when you hit that balance. I’ve shown three different return levels, all below the projected return based on our filtering below, with the lowest more than 3.0% lower. Defaults would need to triple to touch that level of return.

The second section in the above table shows your cash flow various periods of reinvestment prior to needed to stop and pull out cash. All are projected at a 6% return. As you can see, your cash flow increases quite substantially as you allow your reserves to continue to grow untouched.  The final row is after ten years of investment without pulling out cash. At that point, you’ve nearly doubled your monthly cash flow protection provided by this kind of reserve fund.

Is This Right For You?

No, not necessarily. There is needs to be an understanding of the risks associated with this sort of investment. The most prevalent is if the rate of defaults soar, than principal loss is a possibility. While not likely to happen, one should be prepared for this scenario. Of course, it would take a tremendous increase in the default rate to see significant capital losses in a properly diversified account, and even so, your risk would be likely limited to a small fraction of your principal.

Big thank you for Mr. WYOR for guest posting here today. Mr. WYOR writes some pretty great stuff at Write Your Own Reality. I always learn a thing or two from his posts. Also find him on Twitter and facebook.

If you’d like to learn more about P2P lending, make sure you read his posts on Lending Club and Prosper.

Thanks again Mr. WYOR!