Author and expert in online loans, David Shipman reveals his secrets to investing in peer loans.
I’m pleased to present our very first of many interviews on this site. I am interviewing both online loan investors and peer lending borrowers for their story on how the online loans revolution has changed their lives. You will never find a more insightful and honest discussion of peer loans than you will going right to the source and the people in the community.
Our first interview is with David Shipman, an investor in online loans with experience in loan underwriting. David spent ten years in consumer lending before the distaste of selling families into high-interest loans and associated insurance products left him unsatisfied. He now works, through the church setting, helping people with various life problems including financial problems. He is a seasoned investor; continuing to trade in the stock market, buying and selling real estate as well as other investment vehicles.
I have included my own comments below in italics so as not to be confused with David’s.
Welcome David, thank you for the time to share your story.
You’re welcome, I appreciate the opportunity to share it.
How did you get into investing in online loans?
I actually stumbled into peer lending. I was reading an article where the individual made a passing remark at peer lending and the rates that could be earned. It peeked my interest as I had never heard of peer lending prior to this point. I did a little research and it intrigued me. After reviewing the more prominent sites I put a little money into LendingClub and have continually added to it thereafter.
Though peer lending has been around since 2006 in the United States, it is just now gaining the momentum to become mainstream. The financial crisis set it back with high default rates, but then nearly all loans had high default rates back then. Default rates on residential mortgages hit a high of 11.27% in 2010, more than eight times higher than the rate in 2004. That rate has come down to 7.4% in the second quarter of 2014 but still has a long way to go.
Now, thousands of investors are joining the online loans revolution every year. It took Prosper nearly eight years to reach the $1 billion mark for funded loans. It took just six months to reach $2 billion and the site is originating more than $100 million in online loans each month. Even with more than $8 billion in peer loans originated, the P2P world is just a fraction of what it could be eventually. Consumer credit outstanding reached $3.2 trillion in September 2014 with student loans accounting for $1.3 trillion and revolving, credit-card type, loans at $849 billion.
For more information about Lending Club and Prosper, check out my recent post Peer Lending Sites Reviewed
I go into detail just how big the market for peer loans could be and what it means for traditional finance in, “7 Rules You Must Know about Peer Lending,” available free to subscribers of this site.
What was the biggest mistake you made when first starting out?
As with any investment junkie “the game” is always interesting. How much can I make and how fast can I do it. I violated what I already knew from underwriting loans in order to get the highest rate of return. I subsequently had a few notes charged off. However, I did spread my money across as many notes as possible so the effect overall was not that bad. However, I quickly realized that proper underwriting is key.
Like any investing, you absolutely must know what kind of an investor you are before you get started in online loans. I know many investors that only invest in high-risk online loans as a form of speculation, much like daytraders invest in penny stocks. In fact, we hear this same thing from Jeff Clements, an investor in peer lending that has made $9,000 and describes his strategy in an earlier post. Their risk tolerance, and their stomach for taking losses, is much higher than mine and they only invest a small part of their total portfolio. For most investors looking for a respectable long-term return, you are going to want to diversify your exposure across loan risk levels or stick to a particular group of risk ratings that suits your needs.
What has surprised you most about peer lending?
I started out with a really small account as I was unsure how consistently the process would work. While I pay attention to my own underwriting I am subject to the underwriting and verification of the information that is being provided. To me, Peer Lending is a very reliable source of higher than normal interest.
This is going to surprise a lot of people in the years to come. As I said, I think the financial crisis gave debt investing a bad name and the high defaults on online loans gave the naysayers too much ammunition. In reality, peer loans are exactly the same as investing in fixed-income bonds only that they are personal loans instead of corporate debt. Online loans will soon be recognized as a new asset class in which all investors will need exposure for true portfolio diversification.
What are the best online resources for borrowers or investors?
It's been a couple of years since I started putting my money into Peer Lending. At the time Lending Club and Prosper were the two main players. I am sure there are more now, but I have been satisfied with the process and platform of Lending Club and have stuck with them. Therefore, I am not very informed of anyone else at this time.
Lending Club and Prosper both have solid blogs that offer return statistics and some other information, but much of it is factual data and more news related. I just finished putting together a resource page for online loans that lists the best sites with some great resources. Of course, I hope you will ‘Like’ this site on Facebook and join our subscriber list. Peerloansonline is a unique site in that it provides information that both investors and borrowers will find useful.
Tell us about the book.
Coming from a lending background I know there were things we looked at to reduce our risk with a given loan. I use my past experience to help me build a portfolio of safe, yet higher return portfolio. After doing this for awhile I decided to put my process in a written format and published a “How To” guide through Amazon's Createspace. This is a free publishing service as allows me to make this information available for just a couple of bucks.
In the book, Building Wealth through Peer-to-Peer Lending, you will learn tricks of the trade, which will help an individual navigate through the selection process. There are things that are important that many don't even consider. For example, the purpose of the loan. Does an individual really care? If you are concerned about back end losses you should be.
Let's quickly consider two online loans. One is for home improvements and the other is for a loan consolidation. What does that tell me? First of all, anyone who is doing home improvements is not only buying their home, but they are invested in the home for the long term. This tells me something about the stability of the borrower. On the other hand someone who is seeking a consolidation loan is a person who borrows to the point of having unmanageable payment levels. Both of these individuals may have the same credit score and thereby pay the same rate. But who is more likely to pay the loan in full? While there are no guarantees the person investing money into their house probably has will give me a greater level of safety than the other loan.
In the book, I go through several areas that are critical to think about. It's an easy read and was put together to be an informative manual. It can potentially save a person hundreds to thousands in potential losses for only the price of a cup of coffee.
I have seen a lot of sites suggest spreading your investment over thousands of online loans for diversification. Investing with the ‘dartboard approach’ will never make you any more than the site average or worse. This is a terrible way to invest and I’m glad David brought up investing on certain criteria. I like David’s example of a consolidation loan versus one for home improvement. Consolidation loans are a big chunk of online loans but they are not my favorite loan type. Just because the borrower consolidates their loans into a peer loan, who’s to say that they won’t run up debt on their credit cards again.
The loan applications provide a ton of information and finding the right criteria that really affect loan defaults can make you a lot of money. Another post published today shows how one investor made more than $20,000 in peer lending and smashed the site average with a 14% return over the last few years.
What is driving the tremendous growth in peer lending?
I think that there are several driving factors. People like to be in charge of their own lives and going into your locale bank or lending institution seems to rob a person of that feeling. In addition, as time moves on we are becoming more of an “online nation” and this really feeds into that mentality. I believe there are a lot of dynamics at play that will make Peer Lending stronger as time marches on.
There is talk through the peer lending grapevine that Facebook is thinking about entering the space. It would be an easy fit for the social network of more than a billion people. Even without FB getting involved, the peer lending revolution is picking up speed and will change the way we think about lending in America.
How do you pick loans for your portfolio?
I have several key points that I look at, which are all discussed in my book. I've given an example above as to one of them. Most of my key points are not the same as what many people look for. There are ways to determine if a person is high risk or low risk. In addition, there are ways to find information that is not disclosed in the portfolio information. For example, how old is the person you are about to lend money to. I am more comfortable lending to a 30-40 year old than I am a 21 year old. Is there a way to determine this. I say yes!
The website Nickel Steamroller provides a tool to test different criteria against online loans data from Lending Club. It takes a few minutes to get the hang of how to change things around to test the results but it’s an extremely interesting and effective tool. Play around with it for a bit and you’ll be amazed at which criteria materially affect returns and which really do not matter much.
How have your returns been?
Because I am a risk conscious investor I tend to seek out the safer loans. My current yield is just under 8%, which I am very happy with. I only have one delinquent loan, which is a carry over from when I first started. There is only a $4 or so balance on it and it continues to linger 30-60 days late. Other than the last of my reckless days I have no had any loans become pass due in well over a year.
Making 8% on a portfolio of low-risk online loans is extremely respectable. The entire stock market has only returned an average of 7% over the span of a decade and that includes some pretty shady companies. Site averages for seasoned returns on Prosper have come down a little over the last couple of years, as would be expected in today’s horrible rate environment, but are still around 9% across all risk categories. The average for loans in the three safest categories is 7%, so I’d say David is doing really well outperforming the average.
How has your strategy changed since you started?
I have focused more on reducing risk where in the beginning I was solely focused on achieving the highest rate possible.
What should investors know about risks in peer lending?
I believe one of the most important things to know is that you can loose a lot of money if you just randomly select notes. One area of reducing risks is to spread your money out in multiple notes, but if you are choosing low quality notes you still run the risk of high losses.
There is a lot to be said for hand-picking your online loans on a specific criteria program. That said, I don’t know anyone that can pick HR-rated loans and only get default rates as bad as the safest rating categories. The loss rate on the HR category on Prosper is just over 16.5% and is more than twice as high as even the C-rated loans. BUT, you get compensated for this risk through a higher effective yield and can still get an attractive return from the higher-risk loan categories. It all goes back to your tolerance for risk. If you can accept some defaults knowing that the extra interest on other loans will even it out, then you can do very well in the HR-categories.
What do you expect for returns going forward?
I'm concerned that rates overall will be raised much higher. I don't expect this in the near term, but they will have to be raised. As rates go higher it becomes harder for borrows to manage their debt. This could result in greater losses. Therefore, having a safe portfolio will become increasingly important.
It will be interesting to see how peer lending reacts to higher interest rates in general. Higher rates for other types of loans should push peer lending rates higher as well but there are a lot of other factors that could help keep rates on peer loans low. The increasing amount of investor money into peer loans is making for a lot of competition in loans. This looks to be a huge factor over the next couple of years and could actually push rates on loans down.
Interest rates also generally follow the business cycle, rising when the economy is growing. If this is the case, then a strong employment picture and increasing economic opportunities should help people pay off unsecured personal online loans.
What is one thing you would like to do over?
I would have not gotten caught up in the lure of extremely high yields on low quality loans and focused on safe high yielding returns from the beginning.
The allure of high yields has been the downfall of many investors, in peer lending and otherwise. Look at how many people lose their money in penny stocks every year, or how many people play the lottery on the dream of getting rich quick. High-risk does not always mean high-return. Fortunately for peer lending investors, there are ways to minimize risk even in the riskier categories. The seven risk categories used by Prosper offer a great start to building a portfolio that will work for your personal risk and return needs.
What are the three tools that every peer lending investor must have in their toolbox?
I believe the best tool an investor can have is an understanding of what the application information actually means. There is more information than meets the eye.
What’s next for you?
I continue to reinvest into more notes as well as adding to my account. Peer lending is part of my overall retirement planning.
Saying that peer lending should be a part of everyone’s retirement planning will probably get more than a few smirks and groans, but I truly believe that in five years it will be commonly accepted wisdom. Investing in personal loans is just as much an asset class as stocks, bonds and commodities and can be safer as well.
Thank you David and I want to thank you, the reader, for joining us. I hope you will join us for more interviews and follow the blog on Facebook and Twitter. Please consider sharing this article with your friends using the social share buttons on the left.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.