After many promises to do so, I want to start a thread on one of my favorite investments, Lending Club. If you could have a risk free way to earn 8, 9, 10% annually would you do that? What do you do when TSLA has earned you millions and now you want to live on the interest? (I kid, but for some maybe not). It is a very handy way to park some cash you need for a while, or do like I do and turn yourself into a mini-bank and park all kinds of deposits, property tax, savings at pay myself fat interest. Read on for the many details and implications The basics: What is lending club? Lending club is a “social lending” company (like prosper, which I have not really looked into). It’s like a dating site for lenders and borrowers. Borrowers come the site to get unsecured (no collateral) loans for various reasons, but usually credit card debt consolidation. Since credit card interest is typically north of 20% they are happy to pay 17-18%. Lender/investors go to the site and sign up to fund borrowers. Lenders are screened twice, once by LC themselves looking at credit ratings, history, employment, etc. Then borrowers can screen them again based on their applications, picking who they want to lend money to. LC says they reject the vast majority of applications they receive. They assign a risk code A1, A2, A3, A4, A5, B1, B2 etc through G each with 1-5 sub groups. Based on this code the borrower pays some interest rate, lowest at A1, highest at G5. LC itself takes fees from payments but has no other interest in the borrowing/lending. So it is a hyper-efficient bank that connects people who have money with people who need some and takes the minimum vig. Contrast this to a regular bank which charges CC holders 22% interest and pays depositors 0.1% interest. I suspect banks HATE LC. How does it work? You make an account on the EXCELLENT lending club website. You connect a checking account and fund it. You invest in loans (issued or secondary notes, more on that later). You then hold notes (portions of debts) which pay monthly. Since the borrower is paying back principle and interest in every payment, you are getting mostly principal with some interest. Notes can be as small as $25. In the interest of diversifying risk most people choose to have many small notes from many people so defaults don’t hurt as much. Some notes will go late, and some will default and be written off. As long as you have enough money in play (think 10 to 20k) you will be diversified enough that defaults can be viewed as a numbers game. You have notes which are paying an average of, for example, 16% interest but with defaults you get more like 8-9%. You are now a banker! So LC pays better interest than bonds, div stocks (worse tax conditions, see below), and is more convenient. Your balance goes up a little every day since notes all have different pay dates. Some of the money is interest and some is principal you should reinvest. If you do need cash you can pull off the interest or some principal repayments too. That is, cash piles up at a fairly brisk pace. This is good for liquidity, and also bad because you have to come back and keep working on it to keep your money reinvested to prevent money from idling. If you ever needed more money, the LC notes are liquid with some caveats. They can be sold on the aftermarket. LC takes a 1% fee for such sales (buying is free). Note however, that in the aftermarket the borrower’s history is visible to everyone. So if you have a note with a steller repayment record and rising credit scores you can sell it at face value or above. If you have notes which are late, missing payments etc, the market value will be less than face value and you would have to discount it to make it sell. Generally though most of your notes will be in the middle and can easily be sold at face value (principal+accrued interest). You are now a bond trader! What is the downside? Nothing really. There is default risk, but you just have to bake that into the overall return and not sweat defaults. LC started before the 2008 recession so they have a track record including bad economic times. The worst thing about it is that it is a sort of hobby. You have to work on it a few hours a week to keep your money reinvested and maybe try to unload bad notes if you are into that sort of thing. Probably the worst thing is that you can’t put as much money in as you might like. I live in a state where you can only participate in the secondary market (more on that below), so I am limited in how much I can plow into it in any given day/week. I am working up my balance to see if I can find a pain point but I suspect it would be impractical starting at 100k unless you were willing to make it a defacto job (an easy one but still). I can still think of no better place for the $1M I won in the lottery tomorrow, if the goal was to produce income to live on. Note that they have regulations to not allow anyone to invest more than a certain percentage, think 10%, of their net worth in LC. They don’t have a way to check this so consider upsiding your net worth when applying. Primary funding and the aftermarket Depending on what state you live in you can sign up for initial funding of loans. I haven’t ever done this (I live in a state that doesn’t allow it) but I get that there are advantages and disadvantages in doing this. The advantage is that LC will set your investments and reinvestments on autopilot. You can set your risk profile (ratings) and they will sign you up for portions of new issue loans. That is nice, but your money is not working or accruing interest while they are in funding. While a loan is in funding, it is waiting for investors to sign up to meet the borrowers goal (say 10k). Until the 10k is met, the money is tied up. Anyone can participate in the secondary note market and if you live in a long list of states including mine, Texas, you must use the secondary market. This has advantages and disadvantages. The disadvantage is that it is a bit of a pain to do, and there may not be enough high quality notes to buy. Some nights I sit down with 2k to spend and spend $200 and stop and come back another night. Some nights it’s all you can eat and I can easily buy thousands. Also the website for secondary notes is HORRIBLE but there are helper sites (more below). One good thing is that notes bought on the secondary market immediately go to work for you. Finally, investing in the secondary market allows you to try to outperform the median investor by, for instance, only buying notes with 12 months of payment history, rising credit scores etc. Or you can get fancy and deliberately buy failing notes that are discounted too much by the seller. If you buy many notes at 5% on the dollar that are near default you only need a few to recover to net a profit. You are now a junk bond trader! See this guy’s good writeup on the topic: http://www.lendacademy.com/foliofn-lending-club-users/. Note that the aftermarket website is a cesspool of people posting notes for sale at outrageous markups, or wasting time by posting bad notes at uncompetitive prices. You HAVE to use savvy searching to find good notes fairly priced, or bad notes properly discounted. These notes are probably less than 10% of all notes listed. The vast majority of listings are trolls hoping you make a mistake. (I have attempted such trolling as an experiment, there doesn’t seem to be any money in it anyway, so why do they do it?). For instance you will see many notes with 1 payment left with a book value of $0.18 selling for $1.80 (or just $.23). If they get bought the seller books an enormous % profit but wow how bored do you have to be? My results: I have had around 20k invested since summer of 2011. The way I calculate it, I have done between 8-10% on a rolling 12 month basis. I only count my performance based on notes invested, because it isn’t LC ‘s fault if I let cash go idle (cash earns 0% interest). In the last 12 months I have earned about $154/month on about 18k of deposits (10% annualized) net of fees and defaults. So if you do win that $1M lottery that would be $8,333 a month. Not bad? You have to pay taxes on that at your top income level (more on taxes below). Results spreadsheet: View attachment LC_only.xls My strategy now: My strategy up to now has been to manually pick notes in the secondary (time consuming) and try to keep risk down. The last few months I have decided to worry less about risk and bend the yield curve up and see where I can get it. I have been buying more and more higher yielding, riskier notes. Now I am using interest radar(helper site) to find notes more automatically and have started a junk bond side portfolio. One thing that is really cool to do, if you are the sort of person who loves spreadsheets and accounting, is to turn yourself into a self-bank. I have the problem of a somewhat variable monthly income that I want to smooth out into an exactly the same monthly income. I also self-escrow property taxes (in TX this is large since we don’t have state income tax). So what I do is model paying my “bank” the monthly property tax payment (due annually) and insurance payments (due every 6 months) and other escrowing payments. I also pay into an employee stock purchase plan at work. I instantly flip the stock and book a 15% profit on the stock every 6 months. So I model withdrawing that amount every month (and deposit the every 6 month windfall from selling it). I add up the monthly deposits/withdrawals and it’s a net withdrawal every month into checking. As long as I keep an extra 20k in my LC account (just earning interest) the accounting is a breeze: the principal payments gather up enough cash that I can just stop reinvesting a few months before my prop tax is due, withdraw it and pay my taxes. This way all my idle cash is earning 8%! Once you start doing this you realize how many of these things you really have. If you have an extra few k sitting around for an expense in 2 months you can add it and you start become a super saver in a lot of ways. I take all the cash gifts my daughter gets and “deposit” them. She is earning 8% until she is old enough to appreciate it. The LC mutual funds One might wonder, why does idle cash at LC pay 0%? After all, they have access to a good safe source of simple interest. For that matter, why make us do all this manual crap at all? It can all be easily automated since it is much easier to aggregate these investments over say international corporate bonds which fund managers do every day? The answer is that they do this, but are very cagey about it. For one, you have to be a “qualified investor” (multi-millionaire), you have to invest at least 500k and they don’t seem to be open all the time. When I asked about it I had to insist I was a multi-millionaire (no) and even then I got tons of attitude about asking. I finally got a confidential book that shows the details. Curiously, they have rather lackluster yields of 5.5 to 8.5%. I have gotten the distinct impression from various questions that they have more investor interest than borrower interest. Rather than do the market thing and bring down loan interest for borrowers they seem to be erecting walls for borrowers: limiting investment size, limiting states that can do initial funding, limiting participation in the mutual fund, not making the secondary website better etc. Secondary websites There is a discussion forum I have not read enough: http://www.lendacademy.com/ The pretty good investment helper site: https://www.interestradar.com/ The latter requires a monthly fee but it’s worth it. Since the secondary website is so awful it is very time consuming to search. Using interest radar, you can set up search criteria to find just the notes you want and they help you buy them (clunky, but works). They also have clever ready-made search criteria you can use, particularly useful for junk-bond buying. I have started to use them for buying deeply discounted failing notes to see if I can profit from that. They say they do 18% with such strategies. Note that whatever search you set up, you will find notes being snapped up before your eyes. This is the apparent restriction; you may need to just buy what you can on any given day and check back tomorrow (or reduce your criteria to be less picky). Taxes As a final note, the income you earn is taxable at ordinary income rates. Worse, LC doesn’t actually help you with this. By law, if you earn interest from any source of less than some IRS threshold the institution doesn’t have to issue a 1099-div. LC (or the IRS) views each *note* as an instrument for this threshold. So may get tax docs for a few large notes if you splurge on but generally will get nothing. So you have to do manual accounting. Me, I just add up all the profits, losses, fees etc and come up with one profit number and put that on my return. May not be 100% right but defendable in an audit. LC vs Dividend stocks: The thing that worries me is that I can easily show that a conservative portfolio of dividend paying stocks will outperform LC for taxable accounts, depending on the assumptions you use. While conservative div stocks will pay out 3-5% div yield, the stock itself tends to go up over time, the div payments tend to go up over time, and the taxes on the dividends and stocks held over 12 months is taxed at a very favorable rate. While it is a whopper of an assumption to say that stocks will appreciate 3-4% a year, it is easy to show that simple dividend stocks are better, particularly when you try to model indexing for inflation. If you were to try to maintain your balance relatve to inflation, you would have to reinvest a portion of your LC interest back at the rate of inflation. Stocks tend to index to inflation on their own. I would be interested to hear other people’s take on this.