Consumer loans offer investors the opportunity to own notes (that are paid based on the cash flow from the underlying loan) with interest rates ranging from 6.03 to 26.06 percent. The process of investing in notes is very different from buying stocks or mutual funds. This article takes an in-depth look at the investment process with Lending Club, the leading marketplace for consumer credit.
When investing in notes, there are some important concepts to keep in mind.
Why? Diversification doesn’t guarantee that your portfolio will achieve better returns, but it does increase the effect any one note can have on the returns of your portfolio. In the seven years since the Lending Club platform launched, 99.9 percent of portfolios with more than 100 notes and/or no more than 2.5 percent allocated to any single note have experienced positive returns. By comparison, portfolios with fewer than 100 notes, and/or more than 2.5 percent of the portfolio invested in an individual note, had negative returns 11.44 percent of the time.
Many financial services firms, including Lending Club, do not pay clients interest on funds not invested on the platform.The issue of idle cash is particularly important when investing in consumer loans because of how quickly cash can accumulate in an investor’s account. For example, a continually performing 36-month B3 loan will provide cash payments totaling more than the original investment amount in only 18 months.
If an investor does not have a system or service for re-investing cash, the returns on investing in consumer loans can be significantly lower than the average return on the loans themselves.
1) Creditworthy borrowers complete a loan application for between $1,000 and $35,000. Lending Club approves approximately 10% of these submitted applications using strict underwriting criteria. Applications meeting the platform’s listing criteria are assigned a grade from A through G and are posted on the platform.
Steps 2 and 3 occur simultaneously
2) Lending Club seeks to confirm the information provided by the borrower. If Lending Club is unable to confirm key information provided by the borrower within 14 days, or finds the information to be inaccurate, the loan is delisted from the platform.
3) Investors get an opportunity to place an order to buy a note, which relates to a portion of a loan. Investors build a portfolio of notes based on their risk/reward preferences. Once there are enough orders to cover the full amount of a loan, no additional new orders can be placed. On average, there is a 7.2 hour window during which a new loan is available on the platform before being fully allocated.
4) Provided Lending Club is able to confirm the key borrower information and the borrower does not withdraw their application, notes are issued to investors. On average, the time between the listing of the loan on the Lending Club platform and notes being issued is 7.5 days.
5) Borrowers begin making monthly payments a month after receiving their loans. Lending Club automatically withdraws payments from borrower’s bank accounts. As Lending Club receives payments from borrowers, the funds are distributed to investors, minus a small fee for Lending Club. An investor with a close to fully invested portfolio could receive between 3 and 5 percent of the portfolio’s value in cash payments each month, although the exact amount will vary based on several factors including the mix of terms and non-payment by borrowers.
Let’s say an investor wants to open an account with Lending Club with an initial investment of $50,000. For purposes of diversification, the investor wants to have at least 100 notes, and to keep things simple, he or she wants to invest an equal amount in each note. The investor decides to buy 200 notes with an investment of $250 in each note. How is the investor going to make the initial investment, and will he or she reinvest money earned from the investment?
Lending Club currently offers two options for facilitating this process:
1) Using Lending Club’s “Options” to find notes.
2) Using Lending Club’s filters to find notes.
Account holders can access these options by logging in, clicking on the “Account” tab, and then the “Invest” tab.
In the upper left-hand corner of the screen there is a small “Build A Portfolio” box where an investor can type in the amount that he or she wishes to invest per note. After filling in this information and pushing refresh, three options appear, with different interest rates going from low to high. The interest rates being shown are the average rates of multiple notes. By clicking on a particular option, the investor can review the details of the notes for that option and revise the list of loans presented or any amount allocated to a loan. Once the investor’s review is over and the list meets their criteria,, the investor can place an order to buy all the notes included in the option or remove several notes from the selection.
(The interest rates associated with each option may change each time an investor uses this option, depending on the investor’s request and the notes available on the platform at the time).
Many investors have more specific criteria as to the type of notes that they want to buy. Directly under the “Build A Portfolio” box, there is a “Filter Notes” rectangle that enables investors to look for notes currently listed on the platform by specific criteria.
At the highest level, an investor may want to buy notes with certain terms (36 or 60 months) or grades; however, Lending Club also enables investors to do extensive filtering of notes using more than 30 criteria. Unlike the “Build A Portfolio” feature, here investors need to manually input the amount they want to invest in each note, and click on each one to add them to an order.
Both of these tools require the investor’s direct involvement to make the initial investment and reinvest the cash flow generated from the loans. To minimize the amount of idle cash, investors may want to regularly visit their accounts – weekly for example – and invest available cash.