Filed under: Investing
October has reminded us that stock prices do not always go up. When volatility returns, some people panic, and others look for alternative places to park their money.
One asset class that has become increasingly popular — and more accessible to everyday investors — is consumer credit. I’ve spent my entire career in consumer banking, and I find the democratization of credit fascinating, game-changing and mostly a good thing. While I certainly do not recommend panicking over the stock market’s recent moves, I do think this emerging asset class should be considered by ordinary investors — and people in credit card debt.
Why Consumer Credit?
Americans like to borrow. And when we do, most of us pay high interest rates and pay on time. There is currently $880 billion of revolving credit in this country (credit card, store card and revolving lines of credit). The average interest rate on this debt is well above 15 percent.
And loss rates are low. At JPMorgan Chase (JPM), the loss rate on the credit card business is 2.52 percent in its latest earnings announcement.
To oversimplify the equation: If you charge 18 percent in interest, and only write off 2.5 percent in credit losses, than you’ve made a tidy profit. During my career, credit card businesses regularly had higher returns than investment banks.
A Very Lucrative Business — for Banks
To lend money, you need money. And banks are uniquely positioned to borrow a lot of money at very cheap rates. Wells Fargo (WFC) has $1.1 trillion of deposits, and it pays only 0.1 percent for those deposits, held in a variety of accounts.
Most banks pay close to nothing on savings accounts. The Big 4 — Citi (C), Wells Fargo, Bank of America (BAC) and Chase — pay 0.01 percent on consumer savings accounts. So, they borrow from us at 0.01 percent, and then lend it back to us at double-digit interest rates.
No wonder credit card lending generates such outsized returns.
Until Now
Some very smart people thought the equation did not make sense. Why were borrowers paying such high interest rates on their credit cards? And why were savers receiving such low interest rates on their deposits? The difference between the interest rate charged on cards and the interest rate paid on deposits went to the bankers. The banks’ primary purpose is to serve as an intermediary between borrowers and savers. But they seemed to be receiving too much money for this role.
Businesses like Prosper.com and Lendingclub.com are looking to change the game completely. Borrowers can apply for a loan on their platforms. The interest rates they will receive will be much lower than from traditional credit cards.
Everyday investors can fund these loans, building up a diversified portfolio. The lending platform will take 1 percent, and the rest goes to the investor.
So, the bet being made by LendingClub and Prosper is that they can do the job of a bank at a much lower cost. And the early results are promising. LendingClub alone has helped to originate more than $5 billion of loans, and it is heading towards an initial public offering.
A Guide for Borrowers
If you have credit card debt, you should consider refinancing with a personal loan from one of these new lenders. A personal loan can offer a fixed amount of money, at a fixed interest rate over a fixed period. It is a relatively straightforward contract, making it difficult to hide tricks, fees and traps in the fine print. The simplicity of a personal loan is a stark contrast to the complexity of a credit card.
And the best part of online personal loans: you can see if you are approved (including the amount you can borrow and the interest rate) without having a hard credit inquiry hit your credit score. Most personal loan companies use a “soft credit pull.” At MagnifyMoney (my website), we have put together a list of online personal loan companies to help you compare and see how much you could save. Reducing your interest rate can take years off your debt repayment.
For Investors, It’s a Bit More Complicated
Investing in a personal loan on one of these marketplaces is very different from putting your money into a savings account. Here are some of the most important differences:
- Your money is not insured by the Federal Deposit Insurance Corp. In fact, you can lose it all. This is a speculative investment, not a safe place to park cash.
- It is not liquid. When you lend the money to another individual, your money has literally been transferred from your wallet to the borrower’s wallet. Banks keep liquidity to fund early withdrawals; no such liquidity exists here. There are opportunities to sell the debt in a secondary market, but this is new and there is no guarantee on the price you can receive.
And consumer lending provides good returns when you have a well-diversified portfolio. If you only invest in a few loans, you are gambling. If you decide to take a bet, here are some tips:
- If you can’t invest in at least 100 notes (at a minimum ticket size of $25, that is $2,500), then you really shouldn’t invest. Personally, I prefer to have at least 250 notes to further reduce potential risk clustering.
- Beware loans that run longer than 36 months. During my lifetime of consumer lending, I have observed the performance of many personal loan portfolios. And the longer the duration, the more likely that the consumer stops paying. Five years is a long time, and there is limited data for any loan originated on the platform over a five-year horizon.
- If you don’t want to spend a lot of time, consider signing up for automated investing, which builds a diversified portfolio for you (and you can specify the maximum tenor of those loans).
- Don’t invest more than you are willing to lose entirely. The asset class (personal loans) is not new. But the companies originating the loans (LendingClub, Prosper and others) are new. The true risk profile of customers attracted to these websites is not yet clear and can have a material impact on the returns. And, with aggressive growth planned going forward, it is not clear how the targeting and risk underwriting will evolve. (Even small things — like the marketing message used to attract a consumer — can have a huge impact on the credit risk of the borrower, regardless of score. As an investor, you have no control over the marketing and scoring).
If this market evolves properly, then it can create a great opportunity for borrowers to pay less interest, and for investors to earn more. For borrowers, there is no real risk. If you have credit card debt at high rates, you should see if you can get a better deal today: There is no downside.
For investors, this is still relatively new territory. It is worth exploring, but with caution. I have my own humble portfolio with LendingClub, and it is generating a 6 percent risk-adjusted return. But I am still going to wait a few more years before I meaningfully increase my exposure.
Nick Clements is a consumer advocate and the co-founder of MagnifyMoney.com, a website that makes it easy to understand the true cost of financial products. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the U.K.
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Source: Investing
