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Tips for Lending Club Investors

Written by Nickel - 17 Comments

Last night I listened in on an online discussion with Scott Langmack, a veteran Lending Club investor who has averaged 12.6% returns over the last couple of years. During the seminar, Langmack shared tips for “beating the average” with Lending Club. What follows is a rundown of Langmack’s four keys to maximizing returns.

1. Diversification is essential

Langmack argued that, in order to achieve maximal stability, you need to hold upwards of 400 notes in your portfolio. Assuming you invest the minimum of $25/note, that works out to $10k. That’s a pretty tall order for a lot of people, and it can be time consuming to assemble a portfolio of that size.

The good news is that he’s not saying that you shouldn’t invest with less. Rather, he’s saying that the fewer notes that you have, the less predictable your returns will be. At the 400 note level, the law of large numbers takes over, and your returns become much more predictable.

In other words, if there’s an expected default rate of (say) 5% for a certain credit grade, you can be fairly certain that you’ll get somewhere in the neighborhood of 20 defaults if you buy 400 notes. If you buy just 10 notes, however, it’s quite possible that you’ll get unlucky and wind up with 2-3 defaults.

While 2-3 defaults might not sound like a lot, that works out to a default rate of 20-30%, way above the 5% expectation. Then again, you might get lucky and have zero defaults, putting you ahead of the game.

2. Select for job stability

I have to admit that this is something that I haven’t paid a lot of attention to, but Langmack’s argument makes great sense. When selecting notes, don’t just look at how much money someone makes. Take a look at what the person does for a living, and how long they’ve been doing it.

If your prospective borrower is a relative newcomer in the retail sector, you might want to tread lightly. Given the current state of the economy, it’s not hard to imagine someone in that position losing their job. In contrast, government employees with a decade of experience are much less likely to experience a bout of unemployment.

3. Select the loan type

When loans are listed on Lending Club, the borrower has to tell you why they’re borrowing. The problem with this model is that you’re relying on the borrower’s honesty. I was thus surprised to learn that the reason for borrowing is actually predictive of default rates.

At the top of the heap are loans to cover vacations or weddings, or to refinance credit card debt to a lower rate. Such loans have an average default rate of 2%.

Next up are loans to cover a car or other major purchase, medical costs, home improvements, or moving expenses. Such loans have an average default rate of 3.5%.

Finally, we have loans for debt consolidation, educational expenses, house down payments, or for business ventures. Such loans have an average default rate of 5%.

Of course, there are some grey areas here… How do you distinguish between someone refinancing credit card debt vs. someone consolidating their debts? While the former is arguably a positive money move, the latter might be that last act of a desperate debtor. Unfortunately, distinguishing between the two can be a bit of a judgment call.

4. Select your rate and expected returns

The last step is to determine what sort of return you’re looking for, as well as how much risk you can stomach. At the low end, Langmack says you can get 7-8% returns with “very low volatility” and “very low risk” by investing in high grade loans. I think the true amount of risk remains to be seen, but the historical repayment rates seem to support his view.

Langmack is looking for higher than average returns — in the neighborhood of 12% — so he targets loans that are paying somewhere in the 12.5% to 20% range. In other words, he skips over Grade A and Grade B loans and heads straight for riskier notes. As noted above, by choosing his loans carefully and minimizing defaults, this strategy has resulted in a 12.6% annual return.

My personal experience

Since I used “Lending Match” to automatically select my original portfolios, I didn’t really look at pay any attention to individual loans. Now that one of the loans in my “High Risk” portfolio is overdue, however, I can look back with 20/20 hindsight.

For starters, here is the original (unedited) description of what the loan was for:

Repayment to family members. Sudden Death of Mom (repayment of expenses)

Debt Consolidation.

Reatin Legal help. (Laywer)

I’m not sure about you, but I wouldn’t have funded this loan if I had looked at it closely. The borrower actually looked quite good in terms of job stability — 14 years with a major airline, and an annual income of $75k, but…

My biggest concern with this loan request (aside from the poor grammar) is that this person appears to have problems on multiple fronts. Not only are they looking to consolidate debt (one of Langmack’s red flags), but they also need an attorney for some unspecified reason. Yikes.

The good news is that this is just one of the 78 (and counting) notes that I currently hold, so it’s not a big hit. Moreover, in the time since I made my initial investments, I’ve made a point of reviewing loan requests more carefully. Hopefully this will further reduce the risk of defaults and keep my Lending Club returns nice and high.

Published on August 21st, 2009 - 17 Comments
Filed under: Saving & Investing

About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

17 Responses to “Tips for Lending Club Investors”

1
lrgche Says:
August 21st, 2009 at 7:51 am
Great tips and very timely advice, just getting into Lending Club myself, but being in TN, I am forced to buy loans instead, this has it’s own list of pros/cons.

Maybe another post to look at that side for those of us in states that don’t allow us to invest directly into a loan.
2
Lara Says:
August 21st, 2009 at 8:21 am
I’m calling LendingClub to see if they’ll host me next. I have similar strategy, but my wedding loans are doing BAD BAD BAD. So I’m skipping of those plus anything related with proposing (vacation, buying the ring, etc).

Overall, I’m still making a good 9.5%. Great tips here. Lending Club rocks
3
GaelicWench Says:
August 21st, 2009 at 9:05 am
I just find it kind of ironic that when I tried to borrow at Lending Club, before I even had my foot in the door, I was dismissed based upon my credit score. I was never even given a chance to explain anything. No excuses, mind you, but a truthful synopsis of my financial background and goals.

In essence, by submitting the truth, it cost me dearly, because I am considered a “risk.” Then you have this individual mentioned by Nickel, who obviously had a great score, otherwise he wouldn’t have gone past the “door”; thusly resulting in default.

Just some thoughts, and apologies in advance if I took anything out of context. Good article, however!
4
My Journey Says:
August 21st, 2009 at 9:06 am
I am a prosper guy here (mainly cause that is what I started with), but I never understood the auto fund/invest option. Why would you let a computer decide who you are going to lend to?
5
Nickel Says:
August 21st, 2009 at 9:21 am
GaelicWench: It’s all about the averages. History has shown that the average default rate for those with a credit score below 660 is too low to allow them in the door. Are there reliable folks below that cutoff? Sure. Just like there are potential deadbeats above that cutoff. It’s very hard to predict on a case-by-case basis, but the overall default rate becomes very predictable when you start talking about really large numbers of borrowers.

I should also note that my own personal deadbeat had a relatively low credit score (albeit over the minimum). It was a Grade E loan. Not the worst, but far from the best. I’m fully expecting some of these loans to go bad. Those borrowers actually pay a significantly higher interest rate to help mitigate some of that risk.
6
mr gee Says:
August 21st, 2009 at 2:02 pm
I’m surprised the wedding loans and vacations have such a low default rate. I stay away from those because I view them as such unnecessary loans. I much prefer credit card consolidation loans.

I only have 15 or so loans, but i’m hovering around 12% so far. There have been a few late payments but all are current as of now.
7
Sam Says:
August 21st, 2009 at 3:02 pm
Very interesting write-up Nickel. For those interested, here’s the link to the replay: https://lendingclub.webex.com/lendingclub/lsr.php?AT=pb&SP=EC&rID=1520972&rKey=91de70ef60910cc6
8
GaelicWench Says:
August 21st, 2009 at 3:48 pm
Nickel, thanks for your response. I guess I tend to take on a cynical approach to causation, resulting in stigmas. Or perhaps it’s because I’m getting older? I do understand your approach, however, and it does make sense.

I suppose over the course of time ever since my ex’s and my bankruptcy (due to loss of job), it’s been a bit of a sensitive issue because we were deemed risky. Then, in the past couple of years many with perfect scores have had to face foreclosure and bankruptcies as well. So long perfect score. I know how they feel, too.

And now, the only reason why my score has once again dipped is due to having purchased a much-needed used vehicle. My other clunker finally drove its last lap after 15 years and 180k.

Borrowing for many has now become extremely difficult; speaking for many as well as myself, we’re all very thankful that you’re here to help us get the loans we need for whatever viable reasons. Have a good weekend.
9
Eric Says:
August 22nd, 2009 at 4:44 am
I always like reading your LC updates. Thanks!
10
Lina Says:
August 22nd, 2009 at 8:26 am
Wow, 400 loans recommended for diversification? Very good to know. I’m at 230 loans right now, and I felt I was in good shape re: diversification. I will build up to 400 though, pretty soon. It makes sense to invest $5k+ in this, less than that, you are kinda gambling.
11
katie Says:
August 22nd, 2009 at 4:03 pm
if you want to sound really smart (and perhaps snooty), the chance that 2-3 of your 20 loans might default has to do with sampling error. whenever you have a small sample that could be adversely affected by one or two events, blame sampling error (and/or yourself ).
12
BuffetFan Says:
August 24th, 2009 at 1:50 am
Lending Club’s a great idea in the beginning but as it gets more attention I suspect the number of dishonest borrowers will increase. I’m seeing a lot more scary borrowers now then earlier this summer. So you have to search a lot harder.
13
Michael Says:
October 25th, 2009 at 10:19 pm
right now in the present moment I’m one broke indivisaul with very little money to save or invest at the end of the month. I’ve spooke with investors and brokers looking forward to investing with them but dont have enough money so I would like to open an investment account starting with very little money for one reason my money is short not long and I’m new to this so I would like to take baby steps $500.00 or more are not baby steps. What can an investment of $10.00 bring me in 3-6 months. Who can I turn to, what banks with high yields would welcome me.
14
Hrantnyc Says:
November 11th, 2010 at 7:00 pm
Very interesting as I also have approx. few hundred loans, w/a default here and there some late pays, and some on the way to becoming defaults.
-Does everyone spend a lot of time to pick loans as I do? Takes a lot of time to choose.
-Return percentages listed…how accurate may they be-taking defaults, below par sells on trading platform, fees, etc…?, yet I am certainly NOT complaining having averaging over 10pct and am in this for approx. a year or two.
Just wish had more of the info for the borrowers on their credit records-more transparency.
Everyone should open a LendingClub account, for their small allocation of alternative portfolio.
Just another vehicle to diversify, w/good returns.
15
Paul Buck Says:
February 15th, 2011 at 8:31 am
Hmm I have a 630 score and LendingClub left me in the door, Hopefully they don’t kick. Anyways I just started lending at 250$ and I’m going to work my way up but right now trying it out and getting the hang of it. So I’ve been searching sites to see how to start this, and I’m happy to have came to this site. The insight I took in will help me succeed.
16
Craig Says:
July 19th, 2011 at 3:04 pm
Hrantnyc, I invested $7,500 at once and found the choosing excruciating. Initially I boosted my investment in each loan from $100 to $200 just to reduce the number of loans I’d have to find. But I found myself forced to choose loans I might not otherwise choose, just because I wanted to get the whole portfolio invested. Now, whenever I notice any sign of trouble on these loans, I sell it and invest in $25 loans. I am slowly weaning the portfolio to more smaller loans and feeling more peace of mind about it. I also reinvest religiously as soon as I have $25 in my account in order to maximize my overall gain. It’s much easier when you only have to find one to four investments at a time. And I’ve developed criteria to make the process more selective and easier.
17
hrantnyc Says:
July 19th, 2011 at 3:24 pm
Thanks Craig-
Just a note…just found out that there is a prime act, BUT need to invest 50G min, OR 100G min for another act w/ just a little lower fees. Like a hedge fund. LC runs couple of these and Scott runs one w/100G min…BUT odn’t feel comfortable w/them not trying to sell the slow loans, as I try to do…11% return is where I am at w/about 8G in…Good investment but, as said earlier, just takes too much time to deploy larger amounts, keeping 25.maximum investment, and having enough to invest in. Wish there was a better way, w/large min 50-100G ok, but w/more hands on to sell slow loans:)/ Maybe someone can do this:)

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