Peer To Peer Lending IRA Fees

Transcription

1 Peer To Peer Lending IRA Fees Peer to peer (P2P) lending through organizations such as Prosper.com and LendingClub.com is in general a high-risk, high-return, highly-tax-inefficient investment. Since the entire return is fully taxable at your marginal tax rate, it makes sense to have any significant investment in P2P Lending inside of a tax-protected account, such as a traditional or Roth IRA. Regular readers know I ve been tinkering with investments through both of these organizations, but only in small amounts in a taxable account. As I become more comfortable with the concept, I am considering allocating up to 5% of my portfolio to these consumer loans. But I don t want to do that in a taxable account. So I was pleased to see that both Lending Club and Prosper have made it possible to invest with them through IRAs. As you might expect, there s a few catches, and these are predominantly high fees. There s no Vanguard or TSP in this realm. Neither Prosper, nor Lending Club, offers IRAs directly. They offer them through IRA custodians, Sterling Trust in the case of Prosper, and SDIRA Services for Lending Club. These are custodians that you might use if you wanted to hold physical gold or other less traditional assets in an IRA. You can t currently hold P2P loans in an IRA at a mutual fund company

2 like Fidelity or a brokerage account like etrade. These custodians, just like Lending Club and Prosper, want to make a profit, and they do this through fees. Those, unfortunately, come directly out of your return. So you have to assess the cost of these fees against the tax savings you get by holding the loans in a tax-protected account. They advertise these IRAs as No-fee IRAs but as you can see, that s not completely true. IRA Fees at Prosper Your fees at Prosper are exactly the same as they would be in a taxable account, 1% of all the payments made by the borrower, plus fees associated with collection efforts. Sterling Trust, however, has a whole new set of fees you need to be aware of. Annual Fee (includes first year) : $200 (increases if > $250K invested) Termination Fee: $200 (You pay this when you move assets away from Sterling Trust) Wire Fee: $30 Withdrawal Fee: None Prosper will cover that $200 annual fee IF you put a full $5K into the account when you open it, and one year later have at least $10K in the account (and keep at least $10K in there.) You re on your own for the termination fee. IRA Fees at Lending Club Fees at Lending Club are similar, 1% of all payments made plus collection fees. SDIRA Services has a different fee schedule: Annual Fee: $100 according to Lending Club, $300 after the first year according to SDIRA Paper Statements Fee: $20 Termination Fee: $150 Withdrawal Fees: $25 (wire) $5 (check) $0 (regularly

3 scheduled ACH transfer) Lending Club, like Prosper, will waive (pay?) the annual fee if you fund the account with $5K, then have $10K in there within a year and keep it in there. Beware of fees What kind of impact can these fees have on your return if you re not careful? Consider an investor who opens a $5000 IRA at SDIRA in order to invest at Lending Club. Let s say he keeps his money there for two years, earning a 10% return, and then decides to roll it over elsewhere to invest in something else. His annual fee is waived the first year but is $300 the second year. Then he pays a $150 termination fee. He also paid a $20 paper statement fee each year. He earned about $1000, then paid about $490 in fees. Instead of the 10% annualized return he earned, he now ends up with close to a 5% annualized return. That sucks. How can you minimize these fees? The main way is by starting big. Make sure you get $10K in there within a year. The easiest way is to just roll over part of your IRA or Roth IRA from another custodian. While these guys can probably do a backdoor Roth IRA, I think I d rather trust Vanguard with that, then just do a rollover. I saw a per-asset fee for Roth conversion at one of the companies, but it s unclear how they would treat cash in a conversion process. You should also

4 make sure you select electronic statements when you open an account at Lending Club/SDIRA. You can minimize the termination fee by investing more money (so it is a relatively smaller percentage of assets) and by leaving the money there for a long time. It s pretty obvious that an IRA isn t the place to experiment with Peer to Peer Lending. You should do that in a taxable account first. When (and if) you re convinced you want to make it a significant part of your portfolio long-term, then you can look into an IRA. What about the bonuses? Lending Club advertises that you get a cash bonus for opening/rolling over an IRA. Don t get too excited. You have to rollover at least $25K to get any bonus at all (0.5%, or $125) and $250K to get the maximum 2% ($5K bonus). It will take much time (and much hassle) to get that much money invested at Lending Club within 90 days. Trust me when I say you ll earn your $125. You can automate the process somewhat, but I d still recommend you forget the bonus and move over a smaller amount at a time. $5K is doable. $250K would make you a giant on the P2P scene. According to Lendstats, there are only 25 investors at Prosper with more than $250K invested. What about defaults? Defaults are common with peer to peer lending. That s why the rates on these loans are generally over 10% and often exceed 20%. A loss due to default can normally be claimed on your Schedule D. Not so when you invest in an IRA. However, that shouldn t matter. In a taxable account, you offset your losses with your gains and only pay taxes on the gains minus the losses. In the IRA, you still only earn the gains minus the losses. You ll still come out ahead in the IRA, as long as you watch those fees. In fact, now that you can eliminate the hassle of having to fill out Schedule D for all those defaulted loans, you ll be much better off.

5 Would you like to get started? One of the ways this website makes money is through advertising and affiliate sponsorships. Both Prosper and Lending Club pay me a small commission if you open an account through links on the site. If you think you d like to get into P2P Lending, via a regular account or an IRA, please use the links below: Prosper Regular Account Prosper IRA Lending Club Regular Account Lending Club IRA How To Get Out of Peer to Peer Lending Using Folio

6 One of the serious issues with Peer to Peer Lending is the liquidity. It can take time, effort, and money to get out of your investments before all your notes come due. If you are reinvesting in the longest notes available, that period can be as long as 5 years from the time you make the decision to get out. What if you need your money sooner? The answer is that you have to sell the notes on the secondary market, known as FolioFN. This is also where you want to to go if you decide you want to sell your underperforming notes. You can also buy notes here, especially if you re looking for risky bargains or if you live in a state where you can t buy lending club notes directly from Lending Club. The seller chooses a price to sell the note at, which can be at par value, at a significant discount, or at a significant premium, depending on how the note has performed thus far. The seller also pays a 1% fee to Folio for the transaction. This is in addition to the 1% that Lending Club (or Prosper) takes to service each loan payment. I decided to get a Folio account when I had my first Lending Club loan go 16 days late because I wanted to look into possibly selling the loan, and what it would take to sell it. I learned a few things from the experience that I wanted to share. 1) The Folio platform is clunky. It s much easier to search the Lending Club or Prosper database than it is to use the Folio database. You can arrange the notes by whether they ve never been late, whether they re currently days late, or whether they re currently days late. You can also just look at the ones that are now current. You can order them by number of payments remaining, yield to maturity, or even original interest rate. But you can t search them by how many late payments the person has made. You have to actually go into

7 every single loan listing to look. Once you do, you can see every contact Lending Club has made with them, as well as every payment they ve made and when they made it. 2) Past Data is unobtainable. I have been unable to find a website such as Lendstats that contains past performance data on these secondary market notes. It s hard to let evidence guide your investing when you don t have any. 3) It s a no-man s land. There are notes advertising a yield to maturity of anywhere from 1200% to -1200%. Notes can be selling at a discount of 90%+ or a premium of over 100%. You could buy a really bad deal. In fact, it looks to me like MOST of the notes for sale are a bad deal. You re either paying near-par for a loan that s already late, or a huge premium that eats up your return for good loans. 4) It s hard to sell new notes. Judging by comments from other users, as well as premiums/discounts offered on the site, it s hard to sell a relatively new note that just went late. You certainly can t sell it for anything near par. Although I can t tell exactly what sells and for what, a proven note that has made its payments

8 on-time for the last year or two can be sold for a significant premium. In fact, of the 21,000+ notes for sale, only 247 (around 1%) have 10 payments or less left. In fact, only 22% of the notes for sale have less than 31 payments left. Although a small percentage of notes sold on Lending Club are 60 month notes, most are 36 month notes. That means nearly 4 out of 5 notes currently for sale on Folio are unproven notes, less than 6 months old. I suspect this is because buyers want at least one of two things out of these secondary market notes: One, a shorter term than the usual months or two, notes with proven payments. Why should they take a flier on a long-term speculative note when they can get a great return for a low premium on a proven note? Especially when the cost of the transaction is paid by the seller. A good place to learn more about using Folio to invest in these notes is a blog written by a Lending Club investors who only invests through Folio. 5) It s hard to sell bad notes. If you re just trying to dump your bad notes, I m not sure Folio is going to give you what you re looking for. I don t get the impression that there are very many buyers of notes with poor payment records, at any price. If your plan, like mine, was to dump relatively new notes as soon as they go into the grace period, you might be better off holding onto them and hoping for the best than selling them at the discount you ll need to sell them at to actually unload them on Folio.

9 (Update: In fact, you can t even sell a late Prosper note on Folio.) 6) You can see what a truly bad note looks like. Here s a current one on the site selling at a 90% discount. It was issued in July 2011, hasn t had a payment for 116 days, A payment failed in December, 4 attempts were made by Lending Club to get payment, a collections agency was engaged in December, no one can locate the borrower, and once a month the collections agency sends an to the borrower. As you might expect, the borrower s credit rating has been dropping steadily. Want to buy this loan? Not at any price. Only 3 payments were ever made, so the investors lost 97% of their principal. Here s another one selling at a 75% discount. Issued in February 2011, no payment for 40 days or so. The borrower had made 11 payments, all on time. The only note on the account is that the borrower filed Chapter 7 Bankruptcy on 2/9/12. Want to buy that one? Didn t think so. Even after 11 payments, the investors still lost 86% of principal. Risky stuff. 7) There are lots of bad deals for buyers on safe loans. If you search for loans that have never been late, and have 12 payments or fewer remaining, you only find 163 loans, half of which are for $10 or less. All are selling at a premium. The typical premium starts at about 5%, which essentially eats up most or all of the remaining return. This tells me it is easy to sell a safe loan at par, but impossible to buy short term, safe loans. In fact, none of the 163 loans currently for sale actually has a positive yield to maturity. Perhaps there s an institutional buyer snapping all of these safe loans with a positive return up as soon as they hit the platform. More likely, few people want to sell these proven performers. In conclusion, I think if you had a need to liquidate a

10 relatively mature peer to peer portfolio from Lending Club or Prosper relatively quickly, you could do it. You ll be able to sell the good loans easily for par or even a bit of a premium. The bad ones and the new ones you ll either be stuck with, or have to practically give them away. Update: In between the time I wrote this, and when it went to press, I was actually able to sell that note. I listed it at par value (minus the current month s interest). I had it up for sale for about a week total, but only a couple of days at that price (I was asking for par plus the current month s interest.) The note only had 3 payments made on it, the most recent one made days late, but was current. Of course, I also lost the 1% fee on it. Overall, IMHO, this was a good price to get for a new note that had apparently barely made its last payment. My Initial Approach to Prosper As regular readers know, I ve been messing around with peer to peer lending. I first opened an account with Lending Club back in October. In February, I opened an account with Prosper.com. I haven t put much money there yet, only $500, which at the $25 per loan minimum, only gives me about 20 loans.

11 The main attraction of Prosper over Lending Club is better returns, at least with Prosper 2.0. Prosper was the first of the two big peer to peer lending services, but the initial investments were a disaster. They shut down for a quiet period, revamped the system, and started lending again in July Since then, returns have been much more promising. Using lendstats.com, you can see that for loan originated between July 2009 and December 2009, the average Prosper return has been 8.4%. That s several percent better than Lending Club from the same time period. My goal with these peer to peer investments is not to ensure safety of principal. I know a significant percentage of these loans are going to default. This is not money I need for decades, so I can afford to take some risk. This is also an incredibly illiquid investment. It would be a major pain to get my money back anytime soon. But it is also an investment from which I expect high returns, and very low correlation with the rest of my portfolio. Not only do I want these 8% returns, I m hoping that by using back-tested data from lendstats, that I can actually improve on that by 2-4% or more and get double digit returns. Here is the method I plan to use to do that. 1) The Repeat Borrower If the future resembles the past, then I can increase my return by 3% simply by only lending to people with previous Prosper loans. 9% for everyone. 12% for repeat borrowers. That s pretty low hanging fruit. The problem is that there aren t all that many of them. There might only be 2 or 3 repeat borrower loans to fund per day. So if you want to

12 invest $5000, at $25 a piece, that s 200 loans. It might take you three months to build that portfolio. That s a lot of time, effort, and money sitting there earning you $0 until it s invested. 2) Riskier Loans I don t even touch the AA and A loans for the repeat borrowers. The average return for an AA repeat borrower for loans originated since July 2009 has been 4.6%. That jumps to 11.8% for a B borrower, and as high as 17% for an HR borrower. The curve is a bit more complex for the first-time borrower. Returns for AA and A borrowers are around 6%. B-D borrowers have had returns of 8-10%. But at the far end of the curve, with the E and HR loans, it drops down to around 7%. So you re looking for the middle of the range. 3) Longer Loans Prosper offers 1 year, 3 year, and 5 year loans with corresponding returns of 4%, 9%, and 12%. That s a pretty hefty liquidity premium, and I plan to take advantage of it. Like the repeat borrower loans, the 5 year loans are also a bit rare, so it is hard to fill a portfolio with them. 4) Homeowners Just like with Lending Club, loaning to those who own their home seems to be a better bet. That may just be because they re less likely to declare bankruptcy, but it at least shows that they can get their finances together enough to buy a home in the first place. Homeowners 9.6% on average, renters have an average return of 8.4%. 5) Have a Job Seems like a no-brainer I know, but apparently some people looking for loans on Prosper don t have a job. Some are

13 retired, others are unemployed. It turns out that the highest returns are from those who are self-employed (9.8%) and employed (9.2%.) The unemployed and other folks have returns around 4%. It s even better if they make more than $50K. You don t want someone choosing between putting food on the table and paying you back. 6) Avoid Business Loans Just like with Lending Club, you don t want to lend to people starting a business. Businesses fail, and when they do, so does the income of the person starting it. No income= no loan payments= loss of your investment. Returns for business loans are a couple percentage points lower than loans for other purposes (around 7%). 7) Reasonable Credit History While the credit score doesn t seem to matter much, and delinquencies and bankruptcies don t make much of a difference, you don t want to loan to people that haven t borrowed much. Look for at least 5 open credit lines, 10 total credit lines, and a 2 year history. This strategy is all from back-tested data. The future may not resemble the past, especially with Prosper continually tweaking their models. But investing without looking at the evidence seems stupid when the evidence is so easily found. I ll keep you updated as I go along. If you d like to tinker as well, click on one of the links on this page. It doesn t cost you anything and I get a small commission when you open an account.

14 10 Things You Need To Know About Peer to Peer Lending 10 Things You Need To Know About Peer to Peer Lending (P2PL) 1) P2PL is new and it s anti-bank. It s hard to blame the folks protesting against banks. I mean, they offer us loans at crappy rates and then they offer us crappy interest rates on our investments. Peer to peer lending has only been around about 6 years, but it gives you the chance to play banker. It offers borrowers a chance to get a lower rate than a bank would offer them, and it gives investors a chance to get a higher return than the bank is offering. Of course, to get it, you have to take on the risk the bank was taking on before 2) P2PL is available from several different companies, but the two largest are Prosper.com and Lendingclub.com. There are significant differences between them. Prosper is a bit older, Lending Club is now a bit bigger. Prosper has you bid on the interest rates you re willing to give a loan for. Lending Club sets the rates for you. I ll be reviewing each in detail in future posts. 3) P2PL is changing. Initial returns, predominantly on Prosper, were very disappointing, mostly because the default rates were astronomical, essentially around 40%. It doesn t really matter what interest rate you re getting when you re losing 40% of your principal on loans. Beginning in Summer

15 2009, Prosper got their act cleaned up. Lending Club has also been continuously refining their model to reduce (but of course, not eliminate) defaults. Looking at loans originating in the last six months of 2009, both Lending Club and Prosper have a default rate (including currently late loans) of 13.5%. That s not great, but at least it allows you to get a decent return. 4) P2PL offers decent returns. Using loans from that same time period, Prosper has had overall returns of 8.3% and Lending Club has had returns of 4.3%. Considering current expected returns for other asset classes (stocks 5-9%, bonds 2-4%, and cash 0-1%), those returns look pretty good. Now, averages aren t everything. If you look at the top ten lenders on Prosper, you see returns of 18-20%, and if you look at the bottom ten, they ve lost up to a third of their money. 5) You can t believe everything they put on their websites. Prosper boasts returns of 10.69%. Lending Club boasts returns of 6-12%, and notes that no lender (investor) who has bought at least 800 notes (at least $20K) has had a negative return. But if you look at returns from July 2009 to present from an objective source, you see returns of 9.2% for Prosper and 6.38% for Lending Club. Those returns aren t bad, but they re not what they re publishing, and because many of the loans are still new since both companies are rapidly growing (average loan age is ~ 10 months), chances are the final returns for those notes won t be that high. 6) Interest rates are not expected returns. Let s compare Lending Club s notes from 2009 with regard to initial interest rate and final return. First, their A and B grade loans (good borrowers). The interest rate was 10.68% on average, but the return (thus far) is 4.58%. Quite a difference. Let s

16 compare to their D, E, F, and G grade loans. The average interest rate was 15.97%, but the return was only 3.96%. It turns out it is a tricky game to set those interest rates right for the amount of risk being taken on. Prosper s data looks pretty similar with regards to initial interest rate. 7) Broad diversification is very important. Since avoiding defaults is such an important part of P2PL, you want to buy a lot of notes. You can spend as little as $25 per note, which makes it relatively easy to achieve broad diversification. There s no excuse not to. 8) Active management plays an important role in this investment. Compared to buying a few index funds at Vanguard and rebalancing them once a year, P2PL is a lot more timeconsuming. Although there are a few ways to speed up the process, in essence you have to pick up the loans you want to invest in individually. It turns out that some borrowers are more likely to default than others. Some of that is priced in, but some of it isn t. Filtering through the offered loans to try to get a better return than average is time-consuming, but can be rewarding. Through Folio, you also have the opportunity to buy and sell notes. Many investors sell off their notes at a discount once the borrower goes late on a payment for instance, or just because they need their money out of the investment before the term is up. If you ve ever wanted to run a mutual fund, here s your chance. 9) Cash drag plays a real effect. No matter how closely you watch it, there will be a drag on returns from the cash in your portfolio. It takes time for you to choose loans acceptable to you and then for them to be approved. Just like in a mutual fund, this will lower your returns, perhaps as

17 much as 1%. At least at Lending Club, you can fund your account using your credit card (for amounts between $250 and $5000 anyway) and use the float to your advantage to minimize the cash drag. 10) Low Correlation. One of the real benefits of P2PL is the low correlation with my other investments. While I suppose if the economy tanks stocks could go down at the same time my P2PL defaults go up, P2PL is such a different beast from my other asset classes that it ought to perform quite differently from both my equity investments and my other fixed income investments. I ll have a few more posts coming up on this subject, including detailed reviews of both Lending Club and Prosper, as well as some tips on how to select notes with a lower risk of default than expected (leading to higher returns) and how to decide when to buy or sell notes on the secondary market. In the meantime, if you d like to get started, shoot me an and I ll send you a link that ll be worth $100 to you if you invest at least $2500 with Lending Club. Or just click on the ads on the page to learn more. Like many ads on this website, I get money if you click on links and open an account.