I’ve been very happy with the service. I’ve lent money to causes ranging from paying off creditors, to dental surgery, to wheelchairs for the disabled. I’ve earned a steady 11% on my investments. I’m pleased to see other bloggers writing about it. It went from skepticism about whether it was a legit business model, to an increasingly acceptable investment option. I would love to see it become a more popular alternative to traditional banks. I want banks to start being competitive again, rather than predatory. We need a better model. Social lending is stepping up to the plate.

My articles about Lending Club are included in a three part series: The Lending Club Primer, Part 1, The Lending Club Primer, Part 2, and The Lending Club Primer, Part 3.

Note: I do not work for Lending Club. I am just a happy customer, and give my personal recommendation.

How Much Emergency Savings Should I Have? Should I invest in more stocks than bonds?

Every personal finance blogger has their own opinion about this. Most of them say you should have at least 3-6 months if you are single, and up to a year if you are married with children. The best strategy that works for me is the one from the New York Times in their story: Legacy of a Crisis: A Generation Shy of Risk.

Basically, it says that your investment risks should reflect more on what you do for a living than your risk tolerance or time horizon. If you work in a steady income, tenured field like teachers or government employees, then your investments can have more risk since you are less likely to lose your main source of income. Your raises are likely to be steady, but not earth shattering. If you work in a volatile field like banking or technology, then your investments should be more stable. Bankers and tech workers tend to have boom and bust incomes just like the stock market – time of plenty, and time of starving.

I fall into the latter category. I have done this intuitively for some time, but the NYTimes article is the first time I’ve seen it explained this way. I have a higher than normal emergency fund to cover basic expenses. I could stretch it out even further if I needed to. I have zero debts – no student loans, credit cards, mortgages or car payments. The reason is because the fewer liabilities I have, the less likely I am to run into trouble if I am laid off. It also affords me some mobility. If jobs dry up in Seattle, I can move where there are jobs. I save my money in cash until I can afford to buy a major purchase. This allows me to dip into the washer/dryer fund if I ran into a hardship year, instead of being saddled with a payment due for the washer and dryer.

My retirement investments are on the conservative side; index funds that are a mix of some stocks and mostly bonds. Once again, this is due to the volatility of my profession. If I end up on the wrong side of a down cycle at retirement like we’re seeing now, it could be disastrous for my plans for a cabana, botox, and leisurely days in Margaritaville.

I opt for a wealth preservation strategy while times are good. My skills could be completely obsolete in 20-30 years. If I end up in a down cycle year at retirement, I may have a very tough time even choosing to delay my retirement. Technology is an industry that favors the youthful, unfairly as it is. In order to keep my income growing, at some point I will need self sustaining income not tied to my employment. Thus, my retirement income is designed to be from more stable sources (not just 401Ks and IRAs), while my career is more volatile in my prime income years.

This is could apply to anyone, but if you work in a field with highs and lows, this is especially important. I’ve seen more than one tech worker surprised by a layoff with a nasty Audi payment and no savings.

Worldcom was my employer’s client during the dotcom boom and crash.  Many of my friends were legacy employees from the MCI days, who saw the company they were loyal to destroy their retirement pensions in scandal.  Many people may say it was their fault, and should have diversified better.  However, these were real people who did nothing wrong other than be loyal and trust their employer.  They didn’t cook the books, nor could they have known.  They paid a terrible price.

I learned to be wary of company loyalty.

The current generation graduating college today is entering a period of financial hardship far worse than the tech bust.  Pensions are rarely offered these days.  401Ks and IRAs have taken over as the retirement of choice.  They were sold as being able to make your own choices about retirement.

Great idea.  However, with the job market shrinking during this massive economic contraction and retirement funds down 40% or more, I wonder if the current generation will view the stock market with the same skepticism I have about working with the same company for 15 years.  A lot of these kids’ parents will be unable to retire when they originally planned.  They will need to stay in the work place longer to make up for the lost funds.  Many children will need to financially support their parents.  The baby boomer crisis with social security just became a lot worse with them now also losing their 401K and IRA values.   We will all collectively be responsible for paying down the debt, fairly or not.  Will there be such a thing as retirement for most of us?

Many people are selling the down stock market as a great time for young twenty somethings to invest.  They may have the best opportunity to make lemonade out of Wall Street lemons.  I hope, though, that there will be a lesson not forgotten.

When someone applies to borrow money, Lending Club performs a credit check.  Based on their FICO score, debt to income ratio, and revolving credit utilization risk they are assigned a credit grade.  There is no direct correlation between FICO score and credit grade.  Lending Club factors in the whole picture on a number of variables.  Read Interest Rates and How We Set Them on exactly how this is done. Lending Club puts a cap on the maximum a person may borrow based on their grade up to $25,000 for the top tier.

Income can be verified by Lending Club by faxing a current pay stub, but this is not required.  However, potential lenders will almost always ask you to do this.  You’re more likely to get fully funded if you get it verified by Lending Club.

It’s not a done deal when applying for a loan with Lending Club, even if you have a top level FICO score.  Approximately 1 in 6 applications are approved.  I’ve read that it is more difficult to get a loan through Lending Club than through their competitor Prosper.com. Even so, defaults do occur.  Let’s take a look at the average default rates.

As of 3-1-2009 on their Historical Defaults page, average 12-month default rates based on risk grades are as follows:

Lending Club has only been open since 2007, so the broad picture is not yet known.  However, independent financial research group Javelin Strategy & Research in January 2009 published a Lending Club Investment Analysis document. In the graphic is a breakdown of the issued, late, and defaulted notes.  Of the total number of notes issued, only 2.8% defaulted.

That’s beating the credit cards by a long mile. The charge off rate for credit cards as of January 2009 is 6.8%.

So who is Lending Club?  What happens if they take my money and run off with my dog and truck?  Well, there would definitely be a tear in my beer and a WTF!  They shut down trading last year to file with the SEC.  They have completed that filing, and are now registered and regulated by the SEC.  (Assuming of course they are now awake at the wheel.)  Money that is in your Lending Club account is FDIC insured like your regular bank accounts.  Money invested in notes are not covered.  As with any investment, don’t put all your money in the same pot, and don’t invest more than you are willing to lose.

Read: The Lending Club Primer, Part 1 and The Lending Club Primer, Part 2.

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.

What is Peer to Peer lending? Lending Club is a social network like Facebook or MySpace, but it connects people for borrowing or lending money. Borrowers and lenders are average citizens, not a banking entity.

Cool. What are the requirements to be a lender? The requirements are similar to opening any other bank account in the United States (US citizens only – Zopa.com is the equivalent in Europe). You must be at least 18 years of age and have a social security number. There are no credit checks for lenders. To transfer money, you need to setup a link to a bank account that is verified through random deposits.

Update: Since the time I first signed up, Lending Club has changed its filing with the SEC and their requirements for lenders is different. You now need a minimum income level and net worth. It is not available to residents of all 50 States yet. Read the details in their Lender Requirements FAQ.I don’t know how they are checking income levels and net worth.

I need some money to visit my alien cousin on Mars. What are the requirements to be a borrower? Ok…that’s cool. We’re not here to judge. Well that’s not entirely true – we’re here to judge your FICO score. I’ve seen some funky things being funded that a traditional bank wouldn’t approve you for. You tell everyone why you’re asking for a loan. They may ask you questions about it (like, if you’ve seen a psychiatrist lately). Most likely, though, we’re going to want to know how you’re going to make your payments if you’re on Mars. Do you have direct deposit from the mothership? Fax the stub to Lending Club and we’ll check it out.

You meet a minimum set of requirements to become a borrower. You submit information for a credit check. Your FICO score needs to be a minimum of 660+, which is a little over subprime. Your debt to income ratio is below 25% (excluding mortgages). Your revolving credit utilization is less than 100%. You have no bankruptcies in the past 7 years, or collections in the past 12 months. There are a couple of other minor details, but those are the biggies. If these things check out, you’ll probably get your money and you’re going to Mars!

How do I sign up? Use my referral link, you’ll get a signup bonus of $25 to try out. Score!

Scored! So how do lenders and borrowers meet up? I am a lender. As a lender, I browse ‘notes’ from borrowers. I can browse their requests for average rates of return, credit score, debt to income ratio, and delinquencies. Basically, I can choose the risk level that I want. There’s a chance that my borrower could default on his/her loan. Looking at the overall picture of their credit history, I can guess how likely they are to pay me back. Just like how loan officers used to do it before they went all "Banks Gone Wild". I can lend my money to only A+ borrowers if I want, or diversify with a few more ‘risky’ borrowers. By lending a portion to higher risk borrowers, I can increase my average rate of return.

The graphic illustrates what browsing notes looks like, and how to define your search criteria for your risk tolerance. I’ll explain more in the next installment.

Read: The Lending Club Primer, Part 2 and The Lending Club Primer, Part 3