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The Gamble of Peer-to-Peer Lending : How to not lose money in Peer to Peer lending

Would you pay $50 for smelly, used socks? Some people pay up to $50 for a pair of smelly rag. If you think they are crazy, let me ask you one more question. Have you invested in a peer to peer or a person to person loan and lost money? If you have, you might have done the exact same mistake the people paying $50 for smelly socks are doing – falling for a story.  Let me explain.

This post is the first of a two post series on peer to peer lending. This post handles the “How to not lose money in peer to peer lending” part and the next post will deal with “How to make money with peer to peer lending”.

How Peer to Peer lending works

Person to person lending or peer to peer lending has been making news the last few years. Several blogs and articles tout person to person lending as a great investment vehicle, even when compared to stock markets.

The basic framework of person to person lending (P2P lending) is simple. A group of people pool their money together and loan it to a person using a platform. It takes the usual middle man,- the banks, out of the picture. The investors can directly decide whom to lend the money to.

We have complained about how big banks gave bad loans to homeowners who couldn’t afford the mortgage or criticised  others for investing in something like Madoff funds. Now that we have seen everything, shouldn’t we make better, perfect decisions?

So peer to peer lending is the perfect way to lend/borrow money? Well, no.

There are no investments in the world where an attractive return comes without risks, and person to person lending is no different. Let me illustrate that with my own stupidity.

My first attempt at person to person lending

In 2009, I had just started paying attention to investing and the interest rates for my online saving accounts were starting to drop. I read about p2p lending, the 10% interest rate sounded golden. I don’t have to give the money to someone and wait for the black box to pay me a handsome amount. I can pick and choose who to lend my money to, I can see their story, their credit rating and what return I will get. Everything was under my control. It sounded very attractive.

With $500, I dived in head first. Lending Club recommended (or may be those were featured loans, I don’t remember) a few notes. I looked at a few of them, eventually chose someone trying to pay for their medical issues and invested $500. That was easy. Somehow they felt reliable and responsible, after all they are looking to pay for their medical issues and not their vacation.  They defaulted promptly the second month.

That scared me out of the entire p2p thing. At least I lost only $500, but losing my entire principal before I even had a chance to get the first interest payment hurt. I swore I would never do that again.

Fast forward 2 years, I had a much better understanding of the investing arena and myself. This time I knew I am useless at judging strangers. So I started looking at it with an academic interest before putting my money. I could see all sort of dumb things I did the first time.

Other than the obvious risk of borrower default as person to person lending does not provide any collateral, there are two classes of risks with p2p lending.

  1. Mis/Incomplete information
  2. Behavioral risk

Information related risks in peer to peer lending

With a bank, you know the bank, you know they are regulated, you know the numbers they give in public are audited and they are backed up by FDIC. But with P2P lending, there is no fiduciary to have a standard interpretation of the credit risks of each borrower in these platforms. As a result:

  • Lenders overestimated the quality of platform underwriting.
  • Lending club verifies about 60% of its borrowers employment or income information. Prosper does even fewer.
  • 36% loans originating between Nov ,\’05 & Jul ‘09 defaulted.
  • Borrower privacy is at risk – Borrowers provide quite a bit of information about themselves to attract lenders to fund their loan. This could lead to their identity being discovered or their information used by identity thieves.

Psychological risks in person to person lending

Even if you discount all the incomplete or incorrect information, there is always the false belief we have that, we will make rational decisions. Ha! Human mind and rationality don’t play well! We grossly overestimate our own ability to judge character and financial information.

Thinking back on how I made my decision to invest in a particular note, I can easily see I was stupid.

  • Lack of diversification : I didn’t do any research on how to choose good notes.  I decided to invest $200 and instead of searching for 8 good notes, I just invested in one.

Lack of diversification

  • Mixing charity with investing, I should not invest in someone because I feel sorry for them : I emotionally connected with a stranger. I fell for the fact that they were looking to fund a medical cause. My evaluation might have been good for charity but getting emotionally involved is not a good investment strategy. I would guess this is one the biggest way people might fail in choosing a good loan to fund. We like stories. We relate to stories that are similar to ours. We all feel moved by someone going through a rough patch and feel that we should help if we can.

Mixing charity with investing

  • Connect with the borrower emotionally and let that dictate our decisions, ignoring the facts: We let our current feeling towards something make the decision for us, this is called affect heuristics. For example, you might have gone through a bitter divorce. When you read about a loan where someone who is recently divorced is looking to remodel their house, you remember how you felt just after your divorce – scared, confused and angry. Even though those emotions have nothing to do with the current loan, you connect with the borrower and fund the loan.

Connect emotionally with the borrower

  • Completely ignore the facts and base decisions on how we perceive people, aka Representativeness heuristic : If two people are looking for a loan, same cause, similar credit score – one person is an artist, the other person is a doctor. Who will you fund? Nothing personal against artists but a lot of us would choose the doctor, because we all have some stereotypes for different personalities. Doctor vs artist, we feel a doctor will be more responsible. But the fact is we don’t know either one of them personally. We make judgements based on an image we have in our mind instead of any concrete facts.

Go with perception and ignore the facts

  • Confirmation bias – the tendency to search for or interpret information in a way that confirms one’s preconceptions.

Herding Behaviour do what everyone does

  • Believing that “feeling” :  I don’t know if there is a psychological term for this, there must be one, if someone knows please let me know. Without asking “why” we feel that a particular loan is a good one. Photos and description have a very strong impact. Look happy and be white. Males, older people and those who appear unhappy have lower chances of getting loans when they have similar credit profiles.risks.

Believing The Feeling

Yes, I made most of the mistakes above. So I gave up on peer to peer lending for a while.

In a recent attempt to diversify our portfolio beyond the usual suspects (bonds, stocks and CDs), I dabbed into peer to peer lending again, this time I did the research to make sure I didn’t screw up again. And so far, I have not. I have experimented with different strategies and have 22 active notes, averaging 8.10%. I will share my strategy on investment selection in part 2 of this series.

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