I love private lending.
As a real estate investor and former mortgage company owner, I have been a borrower of private money as well as a private lender.
Of course, the real estate loans were much larger than what I'm talking about in this private lending model.
In this model, often called note investing or peer-to-peer lending (P2P), investors invest in notes that make up loans to individuals and companies.
Just like banks.
This investing model has been popular in many countries for years, where bank loans aren't available, via sites like Kiva.
It allows borrowers to get small loans easily, and investors like us to make excellent returns from the interest on the debt.
I have a portfolio of notes on the personal and business loans on the LendingClub and Prosper platforms as do many of my friends and family that produce solid monthly returns.
Even though private lending is a relatively new concept for many, the underlying principles of it go back a long way.
It’s the technology and social networks driving it that make it feel like something new.
The principles of private “micro” lending go all the way back to early-1700s Ireland, where Jonathan Swift, dubbed “the father of microcredit,” founded the Irish Loan Fund.
I have to say this makes me SO happy since my family is predominantly Irish.
The fund provided small loans to low-income, rural families with no collateral or credit history.
By the 1800s, more than 300 programs across Ireland were participants, making small loans to individuals for short periods of time.
Jumping forward to 1976, Dr. Muhammad Yunus, launched a research project in Bangladesh with the goal of providing credit to underprivileged individuals with the goal of encouraging self-employment.
Within 5 years, the program had more than 30,000 members and had transformed into the Grameen Bank, which services more than 8 million borrowers today.
In mid-2000, what came to be known as private lending, or peer-to-peer (P2P) lending, soared.
And the online platforms that allowed individuals to lend money outside of a traditional bank began to emerge – including Kiva, one of the first and most successful.
Launched in 2005, Kiva gave lenders the opportunity to provide small loans to underprivileged individuals in developing countries with the goal of combating poverty.
Since 2005, Kiva has raised $425 million to fund loans with a 99% repayment rate. (Yes, you read that right – 99% repayment rate.)
That's where we at the Investor Insights build our private lending portfolio. By investing in small notes that make up one larger loan.
Just like Vincent…
I have been a lender with Prosper.com for a little over a year. This is the best alternative investment I’ve found for the cash portion of my portfolio. I only invest in the highest grade loans that pay the lowest rates (min score I’ll invest in is 720); however I’m making 9.44%. Where else are you going to get that kind of return on cash? The key is being well diversified. For every $1,000 I invest, I invest in 10 $100 loans.
You know, private lending isn’t that much different than just lending money to a friend.
But as we scale up and build a profitable private lending portfolio, deal flow is hard to come by on our own.
That's why we use two companies (Lending Club and Prosper) who connect thousands of borrowers and lenders to each other.
Speaking of investors (aka private lenders)…
Benefit #1: You can earn a great 5-9% return
Ultimately, the reason we invest our money is to earn a return also known as the “yield.”
And private lending offers investors a great return.
Most accounts average a 5-9% return, depending on how risky the loans are. Investors who take on little risk earn closer to 5%. Investors who take on more risk can earn closer to 9%.
On the platforms, all borrowers are rated by how risky they are, with higher grades (like A) being safer and lower grades (like E) being riskier.
A-grade loans are much less likely to default, even in a tough economy. With E-grade loans, the interest rates are much higher (above 20%), but they default more often, especially in a bad economy.
Your return will be the average interest rate of your borrowers minus the rate at which they default (don’t pay their loans back).
Most borrowers get a 13% loan. The typical default rate is about 5%. And Lending Club and Prosper take 1% in fees.
13% loan rate – losses (1% fees + 5% defaults) = average 7% investor return.
Benefit #2: Private loans are much more stable than the stock market
The stock market has returned investors a much higher return over time (about 10%) than private lending, so what makes this investment worth it for you?
In 2008, the stock market had a massive crash (losing around 35% of its value). Real estate fared even worse.
Heck, I lost two properties and had to close my mortgage company so I know first-hand how risky it can be to be invested in unstable assets whose value is subject to the whim of the market.
But private loans never lost their investors money. On these platforms and my own.
Seven years before the crash, I started a mortgage company that made private loans to real estate investors for fix and flip projects.
Granted they were higher dollar loans, but I raised capital from many investors and “pooled” it to fund the loans earning 4% in fees plus the interest rate “spread” which is the difference between what I paid my investors and what my borrowers paid me.
My rate was 15% and I paid my investors 7% so my spread was 8%. Plus the 4 points. So on a $170,000 loan I made $6,800 in fees and $1,133 a month.
Can you say, “Cash cow?”
I ended up having to close my mortgage company – not because the notes we funded went bad – but because the underlying real estate that secured those loans lost more than half its value.
Just because of the market.
That's when I knew that diversification was key to my own success.
And private lenders can diversify so easily on Lending Club and Prosper.
By diversifying your investment across 200 different borrowers on the platforms, you get that awesome stability and consistent return.
Much better than investing in one note that puts all your money eggs in one proverbial risky basket.
With my mortgage company, it was a full-time business to find the borrowers, screen the borrowers, raise the capital, fund the loans, collect the payments, and make sure all the paperwork and compliance was done.
I closed the business in October 2008 and started lending again via Prosper and Lending Club.
Benefit #3: The investment is simple
People need loans. You simply help fund their loans. At its core, that’s all peer to peer lending is.
As a result, investors like myself feel this investment is easier to understand than most other investments.
The average person can barely tell you what a bond is, but handing out a $25 loan to a few hundred people makes sense.
Benefit #4: This can be a passive investment
As your borrowers repay their loans, you will have a flow of cash coming into your account.
Both Lending Club and Prosper have automated reinvestment options for this cash by automatically reinvesting it into new loans you've chosen.
As a result, with just a little bit of work on the front end, your investment can become nearly passive. Your cash is reinvested for you while you focus on living your life.
Benefit #5: You can invest through a retirement account
Investing through a Lending Club or Prosper IRA allows your portfolio to grow tax-deferred.
You can even rollover a 401(k) or invest with a SEP/Simple IRA.
This can mean huge tax savings for you.
Benefit #6: This investment is (somewhat) liquid
The SEC has classified private loans as a security, which means these investments can be bought and sold on a secondary market.
While Prosper’s market is somewhat small, Lending Club’s secondary market is thriving, with thousands of notes being bought and sold per day.
As a result, you are able to back out of this investment if you don’t like it.
To do so, you simply sell your loans on this secondary market and close your account.
The process can be a bit complicated since it can be difficult to know how to price your loans, but overall the process is pretty simple as long as your notes are small ($25 or $50 each).
Getting started as a private lender is simple:
Sound fun? But a little complicated? No worries, I've got you covered.
Be sure to watch the blog for great private lending tips, tactics, and portfolio updates.