# The Lending Club Experiment

## By Mr. Money Mustache

## Mon, 24 Sep 2012 12:00:08 +0000

It’s time to dive in and explore some interesting new investment options.

I have some personal cash set aside, and the newly-minted Money Mustache Foundation has $10,000 of seed capital that we’d also like to put to work. On top of this, I have replaced the old $75,000 line of credit on my primary house with a new $200,000 one*, and the current balance is a comfortable Zero Dollars. So there is a sizeable keg of “dry powder” ready to put to work as opportunities come up.

Now, normally a conservative person saving for financial independence would simply be investing all surplus funds in a pre-arranged series of places every month. Assuming you have no emergency credit card or car loans, you might allocate the first chunk to 401(k) deductions, some to extra principal payoff on your mortgage or student loans, and the rest to index funds like Vanguard’s VTSAX.

Update from 2017: please enjoy this article, but I don’t recommend actually investing with Lending Club until you review the latest results here. My experiment ended up going well for a few years, but returns have soured more recently so I would not recommend following in my path unless something changes.

However, with my 401k already filled up, mortgages paid off, and a reasonable amount already allocated to index funds, I’m looking for learning opportunities with higher potential reward in exchange for more effort and risk. Some of the options under recent consideration include:

- Buying the junky-but-spacious rental house next door to me from the current owner, renovating it, and re-renting at a much higher rate. Or re-selling it for a quick profit.
- Buying an interesting building elsewhere in my own city (possibly on the Main Street) and owning a tiny slice of the town’s commercial district, as a source of rental income
- Investing in some REIT funds for an expected annual dividend of 6-7%
- Trying an investment in Lending Club, where you indirectly lend money to other US borrowers at expected returns between 5.8 and 13% annually.

I’ve been intrigued by Lending Club ever since I read this post about it on my friend Brave New Life’s fine early retirement blog. However, at the time the strategy seemed complicated, I didn’t understand the risks, and I did not have much liquid cash looking for investments.

But over the past year, the investment picture has changed. Cash has accumulated, the US stock market has roared up to record levels (making lump-sum investing just a bit less appealing due to pricier valuation), and great deals on rental properties in my own area have been hard to come by after a sizzling summer of quick sales.

The final piece of the puzzle clicked in at a recent conference I attended in Denver. I got the chance to talk to some Lending Club employees in person about the company and its operations in detail. In summary, Lending Club is a San Francisco-based company founded in 2007 to function as a new, streamlined connection point for borrowers and lenders, replacing a portion of what banks and credit card companies do. It’s high-tech, it is regulated by the Securities and Exchange commission, and it seems fairly honest and straightforward to me in the way it conducts its marketing. After a year of sniffing around its foundations, I decided it was time to try it out.

So I got an account, scheduled a transfer of $10,000, and then did some reading during the five days I waited for those funds to clear.

Brave New Life’s strategy was a good starting point: he used a website called “lendstats.com” to mine 5 years of Lending Club loan data, in order to design a filter which would find him the best range of loans in which to invest. Copying his ideas, I found that the highest historical return was obtained by selecting the riskier investments (credit grades D and below), and further optimization was possible by doing things like excluding renters, insisting on employment history of at least four years, skipping loans from borrowers in California and Nevada, etc.

So I logged into my new Lending Club and implemented the same filter there. By checking and unchecking various boxes on Lending club investment screen, I was able to include and exclude loan applications (called “Notes”) with various characteristics. Each time I adjusted my filters, an adjusted list of qualifying notes would appear – usually somewhere between 200 and 1200 notes. At that point, I was able to click “select all”, and Lending Club would present me with a summary that looked like this:

A summary of the notes I selected (click for larger)

Hey! That was an unexpected result. I could see that Lending club was automatically calculating the average interest rate of all of my proposed loans, subtracting the expected default rate based on their 5-year history of thousands of other loans with these characteristics, and presenting me with an estimated final rate of return (13.07% annually in this case). In other words, the site was doing its OWN data mining for me, making that third-party lendstats page I mentioned earlier redundant as far as I can tell.

So I was almost ready to invest. The only question was whether to use the manual loan selection method shown above, or the automatic “Build Portfolio” feature provided on your home screen when you first log into Lending Club. Here’s an example of what that looks like:

It looks clean and simple, and when you click any of those nicely-colored “Option 1/2/3” buttons, you’ll get a summary of net investment returns after fees and projected defaults. At 13.03%, Option 3 corresponds very closely with the 13.07% net return projected in my manual portfolio screenshot above, because as you can see it does most of its investing in the lower-grade, higher-yielding loans.

The key difference is that when I requested that my full $10,000 portfolio be invested in Option 3, it ended up allocating the whole ‘stash across only 60 notes. That’s $166 per note, more than six times the minimum $25-per-note investment. With all other things being equal, I would prefer to spread the capital across the greatest number of qualifying loans, because it will reduce the “unique risk” in my portfolio without decreasing returns.

As noted in Lending Club’s own marketing materials, the larger your number of notes, the more your performance will trend towards the projected returns, with fewer surprises. In fact, among investors with 800 notes or more, every single investor has made a positive return from Lending Club, with 93% of them in the 6-18% range depending on their loan grade choices.

To resolve this discrepancy and test my hypothesis, I made two separate investments so we can track them separately:

- The first $5200 went to in my manual portfolio of 208 loans of grade D and lower, filtered for borrowers with no delinquencies in the past two years (because that was the only filter I could find that improved the projected results noticeably). 208 was the maximum number of matching loans available at the moment.. projected return after defaults: 13.07% annually.
- The remaining $4800 went to the default Lending Club high-yield “Option 3 portfolio” of 29 loans of slightly higher average grade, projected yield 11.81%.

Here’s the lending club default portfolio for “option 3”

I’m guessing that my manual portfolio will be both higher-yielding and less variable from the projection, if I understand the statistics correctly. But we will all get to see over time – I’ll provide regular updates as these loans pay us back principal and interest, AND we use the gains to learn about some charitable giving options.

Update, 16 Months Later: I assigned each of these purchases to a different portfolio and have been keeping an eye on them. It looks like my custom portfolio with 208 notes is so far performing slightly worse than the Lending Club automatic selection! My portfolio has seen more defaults, which more than eats away my interest rate advantage. However, the LC selection has many more late notes at this point, meaning they might fall behind in the next few months. Stay tuned.

MMM Portfolio:
Weighted Average Interest Rate: 20.43%
Defaults and chargeoffs: 4.8%
Late in any stage: 1.7%

LC Portfolio:
Weighted Average Interest Rate: 18.24%
Defaults and Chargeoffs: 0%
Late in any stage: 13%

I am finding this Lending Club research to be a fascinating experiment in the field of applied statistics. When you look around the web to see what other financial bloggers have said about the service, you run into a raft of interesting opinions and techniques, bordering on witchcraft and sorcery. People will say things like “I am excluding borrowers who are consolidating credit card debt, or buying a new vehicle, because those are just recipes for disaster”. Or, “I’m avoiding the D through F grades, investing only in A-grade notes, because those are the safest”.

Points like those are intuitively satisfying, but when it comes to statistics, you have to ignore your intuition and look at the numbers. Lending Club has already run the numbers for you, and they factor the historical default rate as part of the projected return. Unless you are able to predict a drastic change in the pattern that has developed over the past five years (and over $813 million of loans and repayments even through the 2008 financial crisis), the math suggests you’re better off learning from the trend rather than trying to apply intuition. And the trend is that the higher-interest-rate loans tend to provide a higher return, even after accounting for defaults.

That is exactly why credit card companies make ridiculous profits, and if this experiment succeeds, it is also why Mustachians may be able to earn 13% annual returns by replacing the credit card companies in the role of Risky Lender**.

So it is exciting to me, because the reward is potentially much higher than the stock market, and the risk may be higher too (especially if I’ve done my research wrong!). I’ll be watching every dollar that rolls in on these loans, and adding more to the investment over time as blog income permits.

If you’d like to follow along and try your own Lending Club investments at any point, I’m providing the following link to the service (it’s an affiliate link, meaning the blog gets $25 if you do end up creating an account):

If you happen to be on the borrowing end of things, there’s even a link for that:

Either way, do your research and be aware of risk. If you already have a friend who uses Lending Club, you could ask them for a referral link too – some existing members have the ability to generate $100 referral bonuses for a limited number of friends.

Update! This experiment is ongoing. Read more about it with these other articles in the series:

The Lending Club Experiment – Four Months Later

The MMM Lending Club Headquarters – where it stands today

Footnotes:

* I signed up for the new home equity line of credit in June, after interviewing and comparing rates and fees of all the major banks. The winner ended up being a local credit union that was originally founded to help Colorado University faculty, and it has been a pleasure dealing with them.

** I’m sure there will be questions about the ethics of lending money at high interest rates. After all, I feel that credit card companies are often predatory in their own lending practices. The quick answer might be to look at the net economic effect of investing in Lending Club. By increasing the pool of investors, you’ll tend to drive down interest rates for borrowers, and lower the share of loans that go to credit card companies. This might increase the desirability of borrowing to some people (which I’d say is a bad thing), but on the other hand, it decreases the prevalence of extremely high interest rates, flattening the spread to a level that might become more economically efficient (good). Plus, the proceeds go to you. What will YOU use the income for? Will it provide a net societal benefit greater than that which a bank or credit card company could produce with those profits? It’s an interesting question to ponder.