WARNING: Why Peer To Peer Lending is a BAD INVESTMENT

What's up, you guys? It's Graham here. So as usual, it's a Sunday night, I'm at my computer, and instead of watching PewDiePie and Ownage Pranks like any normal person would do, I'm sitting here busy looking into peer-to-peer lending. From doing so, I found some very severe issues and faults that I felt really need to be addressed for anybody considering putting money in one of these websites.

By the way, anytime I make a video like one of these, no joke, it takes me probably three or four times longer than just about any other topic because I spend hours upon hours of research reading every single page of the fine print to be able to uncover some of these issues that most people just aren't aware of. So because of that, if you guys appreciate that, just make sure to drop a like so I can finally stop asking for likes. That's it! I appreciate it. Thank you.

So really quick, let's start here. For anyone who's unfamiliar with what peer-to-peer lending is, these are websites such as Prosper.com or Lending Club.com that just act as an intermediary to match people who need to borrow money with people who have money to lend. The benefit here is that because these peer-to-peer companies have lower overhead compared to traditional banks, they're able to lend money at a lower interest rate to borrowers and give you the opportunity to lend your money that was previously reserved for larger banks or commercial lenders.

So they're basically offering you the opportunity to be the bank for someone else and get paid back that interest. The other benefits of doing this is that you don't need to lend all of your money to one single person either. Instead, you could spread out your money towards hundreds of different people with as little as $25 per loan.

This means that if you have a thousand dollars to invest, to twenty-five dollars each, you can loan out twenty-five dollars to 40 different people. This way, if one of those people doesn't pay you back, it's really no big deal—it's only twenty-five dollars—and you still have thirty-nine other people who are paying you back with interest. Speaking of interest, because of course, we all care about how much money we can make from this, Lending Club charges an interest rate that's pursuant to the creditworthiness of that borrower.

So for a borrower with great credit, great income, and low debt according to Lending Club’s so-called risk analysis—which I disagree with, and it's a huge concern of mine that I will address a little bit later on in the video—could hypothetically have an interest rate as low as 6.46% annually, whereas maybe someone else who has nothing to lose, with terrible credit, terrible debt, and terrible income, who has a high risk of defaulting, might pay as high as twenty-seven point two seven percent interest, and obviously of everything else in between.

These loans also range from a three to five-year term, meaning that if you want to get paid back all your money with the full amount of interest it's promised to you, you're going to need to hold on to that investment for at least that amount of time.

Okay, so that's all the sunshine and rainbows and unicorns bit, and it all sounds really good on paper. If it worked exactly like that, I would totally be happy. I don't even know where I should start with this, so let's start with one of the minor concerns first, and then everything else is just going to get worse from here.

Now first, we have the inevitable fees, and this has got to be my least favorite word in the entire English dictionary. Every time I hear the word "fee," I just like, huh, I hate fees. Now as an investor, Lending Club charges you a 1% fee from any monies collected from the borrower. So from whatever return you are anticipating you're gonna get, just subtract 1% from that as Lending Club's fee.

Now to me, that 1% fee seems a little bit high, especially since they're also collecting up to a six percent fee from the borrower side on this as well, and also considering that Vanguard's fee is 0.04 percent, and Fidelity now offers fee-free index funds that charge 0%. But you know, I guess it is what it is. 1% is 1%. I just—I don't like fees, but there you go. It is what it is.

But then we get into something interesting here. If the borrower does not pay back the money that they owe, Lending Club charges a 40% fee on any amounts collected on the delinquent loan that went to litigation, and that amount is already net of their fees and expenses, and 30% on all amounts collected on a delinquent loan in the cases not involving litigation.

So now, if you're anything like me, you're starting to wonder what are the chances of actually getting my money back if a borrower just decides not to pay? So of course, I did some research into this, and I found out that according to the New York Fed, only about 12 to 13 percent of consumers actually paid back debt collected by a third-party collection. Basically, let's call that like your chances of getting your money back are 1 in 10.

So that then got me thinking even more: what are the chances that one of these borrowers is just going to default on the loan, and how often does this happen? What I found was actually pretty shocking. According to them, since their entire history beginning back in 2007, they've issued nearly 32 billion dollars worth of loans, and from that, 2.5 billion dollars has been charged off and unpaid.

This means that there's a default rate of about 7.8 percent overall over their entire history of operations. So this means for every 100 loans you issue, chances are of those about 7.8 percent are not going to pay you back and are going to let that just slide and oops and walk away. So what do they end up doing in the instance where that 7.8 percent doesn't pay you back?

Well, chances are they end up selling off your charged-off loan to a third-party collections agency for pennies on the dollar. In that case, you end up getting paid back whatever Lending Club has received with selling off your loan—Lending Club's take, net of their fees—which let's be real, if you invested $25 and that went unpaid, any sort of debt collector is probably buying that debt for about 4 to 7 cents on the dollar, which means a $25 loan might only be worth about $1 to a debt collector. Whatever Lending Club ends up taking from that.

And keep in mind, since the borrower's agreement is between themselves and the third-party peer-to-peer lending website, you personally can't do anything about that because again, their agreement is between the borrower and the company, not with you and the borrower.

So I think it's pretty safe to say that if you invest and the borrower does not pay you back that loan, the chance of you getting paid any of that money back is pretty slim. And of course, to play devil's advocate here, it might only be like $25 here and $25 there, and it's more important to look at your overall net return and not just at what your losses are. If you could be making money from everywhere else, it doesn't matter if you get charged off here and there, but there's more to it than just that.

That then brings us to our next issue here, and that is that it becomes very difficult to pull your money out once you invest in one of these notes. Technically, you're tying up your money for three to five years until that loan is paid off and matures, and that also assumes that your loan is paid off on time. If not, hypothetically, this loan could be going on even a little bit longer than that.

So if you need your money any sooner than this, you're forced to sell all of your notes on the secondary market, usually for a very steep discount, which means that you might only receive back between sixty and eighty percent of whatever your remaining balance is. So pretty much, yeah, if you want your money out early, there's nearly no way around it. You're gonna be losing some money, and something like this is terrible for anyone who wants any sort of reasonable liquidity just in the event some other better investment comes up and you want to move your money into that.

You're not really gonna be able to do it if your money is tied up in one of these peer-to-peer lending websites. So if you do something like this, you really got to be okay with locking up your money for really three to five years before you're gonna be able to see the full amount back.

But okay, despite that, let's say you do invest with them and you do get a decent return. Well, then the next issue that I see here, and it's a very big one, is taxes. This is taxed as ordinary income as per the IRS, and that means it's taxed at your highest marginal tax rate. Depending on how much money you currently make, this could end up being a lot of money.

When you compare something like that to long-term capital gains—which for most people you're watching is just 15%—that becomes like a very big difference between the two. To me, from a tax perspective, that really just doesn't make any sense because you're tying up your money anyway for three to five years, so you may as well just go for a long-term capital gains rate instead. But these peer-to-peer lending websites don't work like that, so it is what it is. It just doesn't make sense to me to do that just from a tax perspective.

But here's now where we get to the really juicy stuff and where I get very hesitant about ever investing in peer-to-peer lending. Now, not all, but many of these peer-to-peer borrowers don't go through traditional financing to get a loan, like through a bank. Why is this? Well, most of the time, it's because the borrower does not have the debt-to-income ratio or the credit requirements to get a loan from any sort of traditional lender, or maybe they just don't want to go through the bank's traditional verification process to actually make sure they can pay back that loan.

This means that you as the investor are potentially taking on debts that banks have deemed too risky to invest in, given the rate of return that's paid back to you as the investor. I almost see this personally as like you just getting the leftovers of what like the banks didn't want to invest in, given that they have the funds and the scalability to issue loans right now at pretty cheap rates.

With that concern of mine, Lending Club assumes no risk in analyzing the creditworthiness of the borrower, as noted by what they say here in their fine print, which by the way took me forever to find this, so hit the like button. Member loans are made without obtaining any documentation of the borrower applicant's ability to afford the loan.

Then you have this gem sentence right here: although we may perform income verification, the platform's underwriting credit and pricing decisioning may be based on stated borrower income rather than the verified income. This here is exactly what I'm most worried about, and that is stated income. When's the last time we saw people using stated income? Oh right, that was like 2006 and 2007.

So from my perspective, there's really nothing much preventing someone from going on this website, putting in their stated income as something that's not entirely unbelievable, then getting a loan from that and then running off and never paying it back. I just have a feeling—I have no proof of this—but I have a feeling that this happens more often than what you would think.

Sure, something like this will eventually go on their credit report as a collections, and it will ding their credit, but for someone who doesn't care about that and isn't necessarily trying to get loan after loan, if they just want to do this a few times, this just seems absolutely ripe for abuse for anyone who wants to take advantage of this.

Especially if Lending Club isn't personally verifying all of their income and debts and everything else that they state is true on their application. Yes, it is true that lying on an application like this is fraud, but what are the chances that any of these peer-to-peer lending websites are really going to go after someone and prove that they lied on the application when it's simply easier just to write it off as a loss, sell it off to the third-party collections agency, and then move on to whatever is next?

What makes this even worse though, when it comes to default rates, is that this will absolutely increase if the economy worsens or goes into any sort of recession. This is basically the first thing that people stop paying whenever they lose their job or fall on hard times is any unsecured debts like credit card debts and personal loans because they think, "What are companies gonna collect from me if I have nothing to give them?"

These debts are not secured against anything else, and the answer is pretty much they're gonna get nothing. Many of these companies just end up selling off that debt to a third-party collections agency; the borrower just ends up getting some angry phone calls for a few years, eventually it stops, it goes away, they got the money, and then after seven years their credit report is as good as new.

This leads me to think that whenever our economy worsens—whenever that might be—you’re going to see the returns you’ll get from peer-to-peer lending drop substantially as more and more charge-offs occur. This is really at a time where if the economy falters and goes down in price, this is the precise opportunity where you want access to your money to be able to take advantage of a lot of the low prices out there and continue buying elsewhere.

But, oh wait, I totally forgot—you can't do that because your money is tied up for three to five years in peer-to-peer lending. It’s because of those reasons as well that I would strongly advise all of you guys watching to look into this very closely and do your research to determine if this is really the best strategy for you to invest and get your return.

If not, just go elsewhere, but that is entirely up to you. Not financial advice, just for entertainment purposes only. So with that said, you guys, thank you so much for watching. I really appreciate it. If you guys enjoyed videos like this, make sure to smash that like button. Also, feel free to destroy that subscribe button and destroy that notification bell so YouTube notifies you anytime I’m posting a video.

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