Revisiting Passive Income With Lending Club
UPDATE (11/16/2010): Lending Club has ended their “free $25″ promotion, however I still recommend signing up, depositing a little bit of money, and trying it out. It’s really a nice source of true passive income.
It’s been a long time since I’ve written about Lending Club (aside from reporting my performance metrics in my monthly passive income updates), so I thought it deserved a revisit. Since I originally wrote my review, Lending Club has made a lot of really nice changes to their website, making it more user friendly and visually appealing. In addition, they’ve introduced some new types of loans that you can invest in, which I’ll explain further in this article.
The bottom line for me is that this income is pure passive income. Yes, creating a niche website is eventually passive income, but still requires a good amount of upfront work. Investing with Lending Club is very much a “set it and forget it” type of passive income, where you probably only need to revisit it monthly to check on your performance and invest in additional loans. Best of all, you can try it risk free (no deposit needed) because they will give you $25 free if you sign up with this link. Keep reading and I’ll get into the nitty gritty details.
What Is Lending Club and How Does It Work?
Let me refresh you briefly (because I already wrote about this before). In simple terms, Lending Club revolves around social or “peer-to-peer” lending. They broker loans like a bank, except that they use funds from people all over the internet. Let me break down a very simple example for you:
John Doe wants to remodel his kitchen, and estimates the cost will be $10,000. His credit is very good, but based on what he’s researched, he would have to pay a 10% interest rate on a loan from his bank. Let’s assume he can’t take out a home equity line of credit.
John decides to check out Lending Club, and notices that with his credit profile (great credit score, no recent delinquencies, low outstanding loan balances currently), he can obtain a loan at an 8.5% interest rate. This is great! Over a 3-year period, this should save him at least a couple hundred dollars over what the bank would charge in interest.
Lending Club reviews John’s application, performs a credit check, takes into account his current income and other outstanding debt, and approves John’s loan. Now, John’s loan appears on Lending Club’s website, and people like you and me can invest in John’s loan.
Wait, I don’t want to invest $10,000 in some stranger’s remodeling project. You probably don’t either. This is the great thing about Lending Club. You can invest in John’s loan for as little as $25. Because John is a very low risk investment (based on Lending Club’s background and credit check), you’ll earn an 8% interest rate on the investment. John is paying 8.5%, so that .5% “spread” is what Lending Club keeps as its income on this loan.
After enough people invest in John’s loan and the loan reaches the $10,000 funding mark, the loan becomes active. John makes monthly payments for 3 years. He can choose to pay it off sooner if he wishes. As a Lending Club investor, you receive your share of John’s payments each month, a part which is principal (i.e. the original money you invested) and part interest.
What’s the Risk Involved?
Because you’re going to be earning interest at rates in excess of 7% (the average is between 9-10%), you have to expect more risk than a regular bank savings account (which has virtually no risk, but may only pay 1-2% interest). In my experience, the risk is relatively low compared to the return you’re receiving. If you stick to lower interest rate loans (7-8%), you’ll probably find that you never run into someone who doesn’t pay back their loan in full.
One thing I love about Lending Club is that they are extremely transparent with the information that they share. They aren’t trying to take your money and run – they want you to be fully aware of the risks and they provide plenty of information to back it up. Here are some actual statistics from Lending Club:
First, here’s a summary of the loans Lending Club has both approved and denied to date, since its inception in 2007:
It’s staggering how many loans requests they’ve denied - approximately 90%. This goes to show you that before you even see the loans in which you can invest, they’ve done a lot of background work to weed out the potential borrowers who aren’t credit worthy.
You’re probably also wondering – how often do people default on their loans? It’s going to vary to by loan grade (i.e. Lending Club’s rating of risk, which corresponds to the interest rate you’ll receive). In my experience, I’ve had 2 loans default out of 63, and this is actually worse than what the average person experiences. For what it’s worth, my two loans that defaulted were two of my lowest grade loans (and were earning me a 12% interest rate). None of my grade A loans (7.5-9.0% interest rate) have defaulted.
Here’s a chart showing all loans Lending Club members have funded, with the # of defaults for each loan grade. You’ll need to click the image to enlarge it, but I’ll also recap the default %’s below.
% Of Loans Defaulted (By Grade)
A – 1.05%
B – 3.31%
C – 5.24%
D – 6.36%
E – 9.35%
F – 15.79%
G – 17.72%
As you can see, the risk increases significantly as you move toward the lower grade loans (as you would expect). If you’re risk averse, you can stick with A grade loans which have an average interest rate of 8.16%, and you will rarely, if ever, deal with defaulted loans (1 out of 100, on average).
The last column in the chart above, net annualized return, takes into account the default rates. It looks like the best value is actually with E grade loans. Although the default rate is around 9%, the average interest rate of 16.57% more than makes up for it. I wouldn’t recommend that everyone invests in these loans, but if you’re willing to take on a bit of risk, you’ll get good value here.
How Does Lending Club Compare to Other Investments?
Rather than do all the research myself, I’ll post an image that Lending Club has up, which compares itself to other investments (over the last 3 years):
Obviously Lending Club is only going to compare itself to investments that it has outperformed, but this is still a pretty compelling argument for Lending Club.
How I Use Lending Club
I consider myself to be fairly risk-averse, so I really like to stick with mostly grade A loans, with a few grade B loans sprinkled in. Also, I don’t keep a very large % of my portfolio with Lending Club. I originally started with about $500 in my account, and have since deposited anywhere from $50-100 each month. As I become more comfortable with it, I find myself investing more. Generally, I will invest only $25 per loan, to diversify my Lending Club portfolio as much as possible. If I see a loan I really like, I’ll invest $50.
In case you want to follow along with my fairly conservative “strategy,” here is what my filter looks like for when I’m browsing loans (a.k.a. notes):
The 60-month notes are one of the new additions to Lending Club. Previously, you could only invest in 3-year (36-month) notes, however now the 5-year notes are available. Here, your money will be tied up for a couple more years, but you’re compensated with a higher rate (typically 2-3% higher) over that period. I don’t invest in many of these, but I will select one from time to time if it interests me.
In addition to this filter, you’ll be able to read the descriptions about what each loan is for. You’ll first see a general subject line, and then you’ll be able to click through to read more detail and see any questions that other lenders have asked the borrower (for which the borrower usually provides answers). Here’s a snapshot of some of the notes I see with the above filter applied:
[Click to enlarge]
One other thing I forgot to mention – as you receive monthly payments from your loans that you invest in, you’ll eventually accumulate enough money (at least $25) to continue investing in loans. Each month, I’m able to invest in additional loans without even depositing more money. The interest + principal that I receive is usually enough to continue investing more and more.
Conclusion and a Free $25
Overall, I think Lending Club is a great place for a small portion of your investing portfolio. Yes, you’re faced with higher risk compared to CDs and other similar investment vehicles, but you’re compensated with interest rates that exceed most investment types, including the current stock market (broadly speaking).
One great thing about Lending Club is that you don’t need to spend any of your own money to try it out. They’ll give you $25 just for signing up, but you’ll need to click through my link below (they don’t give any money if you’re not referred by someone). With this $25, you’ll be able to invest in one note, just to try it out. If you like it, you can obviously deposit more money. While you need to fill out a brief application to create an account, you don’t need to provide any credit card or bank information to get the free $25 (in case you’re worried about that).
I highly recommend giving it a try, and you’ll get a sense of what true passive income is really like. I know it sounds like I’m constantly pushing Lending Club, but that’s only because I’ve used it for almost two years and have had nothing but good experiences.
If you have any experience with Lending Club or questions for me, please share them in the comments!
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