Rainy Day Pennies | Debt Free Living and Personal Finance

In my first installment, I gave a brief introduction on how to become a borrower or lender. Today I’m going to talk more about it as an alternative to a traditional bank loan, and an investment alternative or supplement.

Alternative to a Traditional Bank Loan. In order to borrow from Lending Club, you will need a minimum FICO score of 660. If you have good credit and payment history, this may be a good alternative to a traditional bank loan. The rates are competitive, but more than that, you might be able to get a loan for things most banks won’t give you money for. A lot of banks have tightened up lending, and aren’t lending for even things like small business growth. If that is the case, you can take your plea to Lending Club and see if a community of lenders are willing to invest in you. Banks usually won’t give you an unsecured loan for things like cosmetic surgery, but it is a request I see frequently on Lending Club.  Many from people with birth defects or accidents.  Some from strippers looking for a career enhancement.  Hey, as I said before, we’re only here to judge your FICO score.  If your FICO score is good, you will usually get the money.

All loans from Lending Club are fixed rate on a three year term. The minimum payment includes principal and interest. At the end of three years, your loan will be paid in full. There are no prepayment penalties. If you want to borrow the money and pay it back in a month or two, you can. If you are late on a payment, you will be charged a late fee. If you default on the loan, Lending Club will report you to a collections agency, and you will suffer the appropriate credit penalty.

Investment Alternative/Supplement. Most “High Yield” bank accounts are anything but these days. CD rates are pathetic. I need a place to stash my short term money that isn’t tied to the stock market performance. I think of Lending Club loans like a 3 year CD that might terminate early (if my borrower pays in full early). When my borrower makes his/her monthly payments, I get back my proportion of the principle I contributed to the loan, plus interest earned.

Are there risks? Sure. You are counting on your borrower not defaulting. Lending Club puts a few restrictions on how much money a borrower can borrow (we’ll talk about that in the next installment).  There are a couple of ways to diversify your risk.

1. Look at the FICO scores of the borrower, and determine your level of risk. A+ borrowers rarely default. If you want to play it safe, you can choose to lend only to A+ borrowers.
2. Diversify with a mix of low/high risk loans. You can improve your average rate of return if you choose a few higher risk loans. This is how banks used to make their money. They would have a collection of loans from people who were pretty much assured to always make their payments, plus a few ‘risky’ borrowers whom they would charge higher interest rates so they could make more money.
3. Loan a small amount of money among many loans. I usually loan $25-$50 per loan over many loans. This way if one or a few of my borrowers default on me (three years is a looong time), then I won’t miss it. This Is also the way banks used to make the majority of their money. If their high risk borrowers defaulted, they could still count on their low risk borrowers to stay ahead.

In the graphic, you’ll see that Lending Club shows you charts with your risk diversification and your average rate of return based on your portfolio. You’ll see how many of your borrowers have been charged late fees, defaulted, or are uncollectable. If your borrower is late, you will get a proportion of the late fee in your monthly collections. If your borrower is in default and given a penalty, you’ll get a portion of the collection fees. If your borrower defaults and Lending Club is unable to recover, then you and everyone who contributed to the loan will lose what they put into it.

There aren’t any fees for lenders, except Lending Club retains 1% of your earnings. So when calculating your earnings, factor that in.

I’ve been lending on Lending Club for about a year, and I’ve found it to be an easy, straightforward process. I browse loans, read the descriptions, and diversify the money I want to spend over many loans. When I receive my earnings, I transfer them to my regular bank account. You may also reinvest your earnings into new loans (minimum is $25). Your earnings when they are not invested into a note will not collect any interest, so it’s best to move them into a new note, or into an interest bearing account as soon as possible.

Update: Fixed error in term rate.  Terms are fixed at three years, not five.

Read: The Lending Club Primer, Part 1 and The Lending Club Primer, Part 3.

Filed under:
Finances, Investing, Social Lending by Cathy