How to Make Money with Marketplace Lending - THE BLOG OF JASON SHOEMAKERTHE BLOG OF JASON SHOEMAKER

Money is a tool that allows you to provide for your family, live comfortably, and enjoy the amazing experiences life has to offer.

Investing the money you’ve worked so hard for is the only way to free up your time to spend it with friends and family, doing the things you want to do. Time is not money; time is much more valuable. Time is the one resource you have that is limited and that you will certainly exhaust.

You can always make more money, but you can never relive your child’s 8th birthday or that once-in-a-lifetime experience that you passed up for work. In order to free up more time and earn more money, investing is one tool to add to your financial arsenal. Real estate and stock market investing are common investing vehicles, but what I’ll refer to as Marketplace Lending, coined by Charles Moldow, is a new investment vehicle that allows you to invest in other people. Marketplace Lending is referred to as many things, such as peer-to-peer (P2P) lending or peer lending, but for simplicity I’ll call it Marketplace Lending. The bottom line is that this is a new class of investments that provides comparable returns to the stock market, earning you more money and freeing up more time.

There are few, if any, ways to “get rich quick” and Marketplace Lending isn’t one of them, but there are ways to build wealth over time. Common asset classes include stocks, options, bonds, and real estate; each with their pros and cons as well as varying degrees of risk and reward. Across all of these investment options, one thing remains consistent; the goal is to minimize risk and maximize reward. Investors are constantly seeking ways to achieve this goal, whether it’s new investment vehicles or new investing strategies.

As the internet continues to grow and bridge the gap between people and resources, we see new technologies yielding new opportunities. Companies like craigslist, eBay, AirBnB, and Uber are examples of this. These are companies that connect real people with real needs to people with the resources they are willing to sell, or services they are willing to provide. In this same way, companies like Lending Club have created an environment for real people to borrow money from real investors, the tip of an iceberg representing a transformation of the traditional bank-based lending economy.

For me, Marketplace Lending has become just one more tool in my arsenal of investing tactics. You can see more about my story with this type of investing, here.

How Marketplace Lending Works

Loans, mortgages, and credit cards are not new concepts to anyone. Chances are, every person reading this has at least one loan to their name, be it an education loan, car loan, or mortgage. Credit is extremely important to how an economy operates, grows and thrives. Ray Dalio touches this topic in How the Economic Machine Works. The traditional process is simple: A person (the borrower) goes to another person (traditionally a bank) to borrower money in order to consolidate credit cards, buy a new car, purchase new furniture, or fund a home renovation. In this transaction, the borrower pays additional money for the convenience of borrowing, in other words interest, and the bank earns that money for the risk and opportunity cost they take in lending out the money.

Banks are able to lend money, largely in part to the deposits (e.g., checking or savings accounts) that people hold in the bank. With this money, banks are able to lend a large portion to borrowers while keeping a lesser portion in order to fund future withdrawals against the deposit accounts.

In Marketplace Lending, you become the bank via technology that directly connects investors and borrowers. Where banks typically lend the money that you deposit in a bank account, you can now lend money directly to borrowers and collect the interest.

In order to reduce the risk of losing the money that banks lend, they assess the borrower’s “credit worthiness,” an assessment of the borrower’s history of paying bills and other financial matters. They look at things like credit score, credit history, current debts, current income, and many other factors, all in efforts to ensure the borrower is able to pay the money back with interest.

So what if you could apply this same structure but allow you to be the investor; you replace the bank? The concept of Marketplace Lending is based on the premise that people don’t need banks to have access to capital, they simply need other people. Thus one person borrows from another person, or in this case, one borrows from many, hence, “peer to peer.” Using online platforms such as Lending Club, people have the ability to remove the middle man (i.e., banks) and borrow money directly from other people at better rates and with lower costs, creating a traditional borrower – investor relationship.

Let’s look at an example of what this might look like:
Andy (the borrower) wants to borrow $10,000 to consolidate his five credit card payments into one and reduce his interest rate from an average of 24% APR. Joes applies for a 3 year Lending Club loan and qualifies for an interest rate of 20%.

Principal (p): $10,000
New Loan APR (i): 20%
New Loan Term (n): 3 Years (36 Months)

If you were the investor, Andy would pay you back the $10,000 + 20% interest over a period of 3 years, or $13,378.89.

Principal: $10,000.00
Interest: $3,378.89
Total: $13,378.89

The example is simple enough: as an investor, you give $10,000 and get $13,379 in return after three years. Yet there are still many questions that need to be answered…

What If I Don’t Get Paid Back?!

Let’s take this a little further by involving other investors. What if you and 99 other people lent our borrower, Andy, each $100 that cumulatively provided Andy a loan of $10,000? You now own 1% of Andy’s loan and Andy would now pay you and each of the 99 investors back $100 + 20% interest over 3 years, or $133.79.

In this scenario, you are now only risking $100 versus $10,000 on the promise that Andy will pay you back. If you’re able to find 99 other borrowers, like Andy, and lend them each $100, you can now invest the same $10,000 with an expected return of $13,378.89, assuming each borrower you lend to borrows at an interest rate of 20% for 3 years. With this approach, all 100 people must fail to repay you in order for you to lose your money. Depending on the quality of the borrower, or their credit grade, only 3-5%, or 3-5 people of the 100 you invested in would fail to repay you on average, leaving you with 95-97 people that pay you back in full, with interest.

Andy (the borrower) applies for a loan through Lending Club. Based on Andy’s credit history and financial status, Lending Club fulfills the loan through investors by breaking the loans into smaller loans, or notes.

Lending Club then distributes these notes across many investors in amounts as small as $25. Thus, as an investor, if Andy ever fails to repay, or defaults, the investor only loses $25. Once Lending Club collects enough money across hundreds of investors, they give Andy his money.

From the investor’s perspective, if investing $10,000, at $25 per notes across 400 different borrowers, if 10% fail to repay, or default, which is high by most standards, that’s only 40 loans, leaving you with 360 paying loans.

Is Marketplace Lending Legitimate?

People tend to be weary of new ideas and new technologies. Not too long ago people questioned Apple’s phone concept and whether people would be willing to do away with the physical keyboard for a touch screen. Apple’s iPhone is now one of the leading Smart Phones on the market.

The concept of borrowing and lending to other people online might be a new concept, but the fundamentals are not. The short answer to the question of ‘Is Marketplace Lending legitimate’ is, “Yes.” But in order to make an apples to apples comparison, it’s important to understand the traditional lending channels before explaining Marketplace Lending and introducing the mechanics of the Marketplace Lending model.

Understanding the Loan Lifecycle – How Loans are Born

Loan Origination: the start of the loan process
Loan Application: a borrower decides they need a loan and applies for a loan by providing required information to the lender
Underwriting: a fancy word for making sure a borrower is legit
Credit Review: the loan underwriter reviews the borrower’s application and provided documentation. This generally includes pay stubs, credit history, credit score, and any other information that can speak to the borrower’s ability to repay and their “trustworthiness”
Credit Grading: once the application is reviewed and approved, a credit grade is assigned with a respective interest rate
On-Boarding & Disbursement: another fancy word for giving the borrower the cash
Loan Issuance: once the loan is approved, the borrower is distributed the funds they were approved for
Loan Servicing: this is the bank tending to borrower’s needs and taking their money
Loan Payments: once the loan is funded and distributed to the borrower, the borrower begins to make monthly payments of principal and interest

Understanding How Traditional Banks Lend Money

Traditionally, a customer would need to go into a branch office, request a loan, and fill out a host of information in their loan application. Depending on what you’re using the loan for, you may have to apply for a specific type of loan from a list of loan products that the bank offers, each with different terms, interest rates and requirements. Some examples include:

Auto loans
Personal loans
Personal lines of credit
Business loans, or
Construction loans

Once the loan application is submitted, it is sent to underwriting where the Bank runs their propriety credit model to determine if the customer is a good risk for the bank to take. This proprietary model is essentially a set of rules that look at the applicant’s information and scores it based on the rules defined by the bank or third party service provider.

During this process, the bank may determine the rate at which to lend the money. In some cases, the borrower may need collateral, such as a car in order to obtain a car loan. This is considered a “secured” loan in comparison to an “unsecured” loan. The difference being that the bank can take your car if you don’t pay in order to collect their money back from the loan. For obvious reasons, this is considered a safer loan and generally will result in a lower interest rate.

Once approved, the loan goes through the onboarding process, where the borrower’s information is entered into the bank’s loan servicing platform, funds are disbursed to the borrower, and the bank moves the loan to their servicing department. From that point forward the loan is managed by the Servicing department where they are responsible for everything from processing payments, handling customer issues, sending statements, and assessing fees.

One interesting aspect that many may not be aware of is that while you might expect your bank to own the loan; this is not always the case. Banks will often sell loan portfolios to other banks or investors while only maintaining servicing rights to the loan, for which they get paid a fee. Banks do this because they are able to defer the risk to another party while continuing to get paid servicing fees from the loan.

While some variation may exist from bank to bank, the process described above by in large describes how the majority of banks operate when it comes to consumer loans.

Appreciating the Quality of the Technology

“I was shocked at how good Lending Club was when we went there… They’re running their programs better than probably 90% of the banks do themselves.”

-Jonathan Morris, Titan Bank

When thinking about the technology that banks use to originate and service consumer loans, many of these big banks are using technology that is outdated and stitched together as a result of bank acquisitions and mergers. Upgrading this technology becomes that much more complex and difficult when working with customized systems that are decades old.

New lending platforms have created loan origination and servicing platforms from the ground up, that are online focused, allowing customers to get loans online rather than going into a physical branch.

The technology used by Lending Club and others is more efficient, more powerful, and more flexible than that of traditional banks. In order for traditional banks to compete with these new platforms, they will need to either launch extremely expensive implementation projects to bring their systems up to date, or partner with companies like Lending Club in order to stay in the consumer lending game.

As with Titan Bank this is exactly what has begun to happen with some smaller, early adopters. On the Lend Academy Podcast, Jonathan Morris of Titan bank talks to his experiences with Lending Club and how Titan Bank uses the Peer Lending platform to participate in small consumer loans.

Lending small consumer loans can be costly to banks due to the sophistication required to properly assess loans, understand their relative risk, and determine their expected return. Without the technology to do this cost effectively and consistently, alternatives must be considered. For Titan Bank, this alternative has been to partner with Lending Club to purchase whole loans. Lending Club originates loans on their technology and allows Titan Bank to purchase whole loans. Titan bank then runs the loans through their credit models and purchases loans that fit their criteria. This allows Titan Bank to participate in the consumer loan space without having to support an entire consumer loan organization and technology architecture. Since partnering with Lending Club in 2013, Titan bank has invested in over 1,000 loans.

An important piece to this story is that banks are highly regulated and therefore must review their banking practices with the regulators prior to engaging in any activity. Titan Bank is regulated by the Office of the Comptroller of the Currency (OCC). Prior to engaging with Lending Club, Titan Bank reviewed its plan with the OCC and setup the appropriate controls and policies to ensure they were meeting all banking compliance regulations. As quoted above, Lending Club was seen to have excellent policies and procedures in place allowing them to operate at bank quality or better.

The relationship between Lending Club and Titan bank is one example of what I expect to be many more in the future. Not only does it validate the quality and sophistication or newer lending companies, such as Lending Club, but it also bridges the gap between outdated banking technology and credit markets.

How Do I Get Started?

7 Steps to Get Started with Lending Club

Go to LendingClub.com and open a Lending Club Account
Fund Your Account: In order to be properly diversified, aim for $2500 – $5000, owning 100 – 200 notes
Wait up to 4 Business Days: It generally takes Lending Club about 4 days to process fund transfers and allow cash to be available for investing
Search and Filter Loan Criteria
– Yield: 17%+
– Term: 60 months
– Markup: <= 1%
– Remaining payments: 60-54 (months)
– Note: depending on what platform you have available to you (Lending Club or folioFn) you may have different criteria to filter on.
Purchase Loans: 100 – 200 loans, assuming $2500 or more invested
Get Paid: Watch principle and interest payments accumulate in your account
Repeat

Conclusion

“Building wealth is like dieting; you can’t reasonably expect to lose a significant amount of weight in 1 day. It takes consistent, disciplined behavior over several months or years.”

-Anonymous

We all seek financial freedom in life whether that means creating passive income or working jobs we love that allow us to live the lives we want for our families. However, time is a fixed resource that must be respected, cherished and conserved. Without disassociating the money we earn from the time we spend, it remains to be difficult to reallocate our time to the things that are most important in our lives, time with friends and family, creating amazing and memorable experiences together. By investing and growing a financial foundation, you can set yourself up to be secure and financially independent while freeing up time to spend as you see fit.

The introduction of Marketplace Lending has created a marketplace for people to access the financial resources they need while allowing other people to benefit through investing and contributing to others. Marketplace Lending fosters a financial eco-system that was never before possible on a large scale, only now possible through technology.

With just a few hundred dollars, a computer and internet connection, you can invest in the futures of other people while working toward the financial freedom that you’re seeking.

While Marketplace Lending isn’t the only asset class that one should invest in, it opens up a new avenue for investors to achieve significant returns that are relatively predictable. The intent of this was to share my experiences and knowledge of Marketplace Lending and specifically Lending Club. Hopefully you’ve found some value and I was successful in providing you the information and tools to get started with investing in Marketplace Lending and start building the wealth you desire in life.

Resources

Lend Academy
Lend Academy Podcast
Lending Memo
Nickel Steam Roller
Lending Club