This article was written in 2014 and quite a lot has changed! A lot about this article is still relevant, but you may be more interested in my most recent post on peer-to-peer lending and why I am moving my money from Funding Circle to Ratesetter.
Out of all the investment and saving options I know of (including property, stocks and shares, bonds, angel investing), peer-to-peer lending is by quite a stretch, my favourite, and of all the peer-to-peer lending sites I think Funding Circle is the best.
I have spent a lot of time on Funding Circle* and in this article I will uncover a few simple strategies I currently use. They leverage the quirks of the site to massively increase your investment return. According to the Funding Circle statistics page, the average lender’s return is 6.4% but these techniques magnify it to at least 9%.
If you know what Funding Circle is already click here to skip to the good stuff.
What is Funding Circle
Simply, Funding Circle* is a marketplace that allows people like you and me to lend money to small businesses. The businesses put up a prospectus, their financial statements and request a certain amount of money. Funding Circle then classifies them in a risk category, A+, A, B, C and C- and the loan is put up to auction. Thousands of investors can then bid for small parts of the total loan amount at different interest rates. For instance I could say:
“I will lend this business £150 provided I get 11.5% interest”.
Once the full loan amount has been raised the people who asked for really high interest rates start getting knocked off.
In this example the business is asking to borrow £200,000 but more than that has been offered, so now investors are competing to beat each other’s bids. If you were to offer an interest rate higher than 10.9%, your offer wouldn’t be good enough. But if you were to offer below 10.9%, you would knock someone else’s offer off the top. As time goes on the maximum rate available decreases until finally the auction ends and whoever was at the front of the treadmill at that point gets the best rate.
Funding Circle also has another way to lend, the secondary marketplace, where people who have already lent money can put their portion of the loan up for sale to other investors. They can even charge a premium and make an instant profit from the sale.
This sort of thing gets my spidey senses tingling. Two different marketplaces where the exact same product is being traded but in totally different ways!
Why You Should Care
Funding Circle is quite hands on and requires a level of knowledge and time to use correctly. Even if you can make an extra percent or two over less complicated options, what difference does that make? I’m not a millionaire so 1% of my savings is hardly anything.
The answer is called ‘compound interest’. The foundation of any good investment policy – simply it means that a small improvement now will be magnified over many years. Let’s say you have £10,000 and you have three choices of how to save that money. You could be fairly savvy and invest in the highest return ‘hands off’ peer-to-peer lending site, Ratesetter, for a satisfactory return of 5.9%. You could stick your money in a bank account and earn 0.5% or you could follow my advice and earn that extra few percent from Funding Circle.
Let’s jump forward 40 years into the future.
£10k invested at 5.9% would be worth £99,904.
£10k invested at 9% would be worth £314,409.
And the money in the bank?
£10k invested at 0.5% would be worth a pathetic £12,221…
That ‘extra few percent’ more than triples how much money you end up with!
My Funding Circle assumptions
The strategies are based on a couple of assumptions. Here’s what they are and my logic behind them:
- Ignore all the information except the estimated return, loan risk category and the market rate for that category.
Funding Circle provides a wealth of information about the companies, including their financial reports and even a message board to contact the company and ask questions. But I know nothing about valuing a company’s likelihood of paying back a loan. I’m not even sure it’s possible to do?
Instead I simply try and maximise the ‘estimated fully diversified return’, which is calculated by Funding Circle from the gross yield, their fees and the risk category of the loan in question.
A little knowledge is a dangerous things so instead of spending a lot of time and energy to choose a few loans I am ‘sure’ about, I think it is a lot safer to rely on high estimated yields and diversify.
Diversification is bad if you’re Warren Buffet or Bill Gates. But it is good for those of us who want the certainty of reliable returns. I try and keep my maximum exposure to any one loan at about than 0.5% of my total investment.
Let’s look at the strategies, going from the easiest to the most involved.
1. Profit from companies ending the auction early
If you go to the statistics page you’ll see this strange looking chart:
What on earth is going on here? Why is the average person getting 11.9% on a C grade loan but some lucky chaps are managing to get 15%? If you watch every loan that ends at it’s prescribed time, you will never see any with rates anywhere close to 15%.
When a loan is put it up for auction, the company has the option to end the auction before the due date. But the longer they leave the auction running the better their rate becomes. It can only get lower as time goes on.
So if you happen to be offering a high rate in a loan that ends bidding early, you can get matched at a rate you never would have got if they had just let the auction run.
As this only happens every now and again, we want to be sure we’re there when it does. The only way to do this is to offer a very high rate on every single loan listed for auction. On most of them we will be outbid but occasionally the bidding will end early and we’ll have struck gold. To do this we simply use the auto-bid feature built into the Funding Circle site. Under the auto-bid settings click on advanced and choose your desired rate.
Here are some recent examples I managed to lend to.
At a 14.7% rate on a C grade loan, there is an expected annual bad debt rate of 3.3%. So after bad debt and the 1% funding circle fee you still expect to make 10.4%. The B rated loans at 14.4% have an even higher expected return of 11.1%.
- Very Simple.
- Totally hands off. The autobid does everything, it even has an option to use 0.5% or 1% of your total funds so it manages your diversification for you.
- Very high returns.
- Very slow. Most loans don’t finish early!
- It takes a sizeable portion of your bankroll, because you need to bid on a lot of loans to make sure your in on the ‘lucky’ ones.
2. Buy just the best ‘value’ loans
Funding Circle is a true marketplace which means that the rates are set by the fluctuations of supply and demand. If there are more investors wanting to lend the loan rates go down, but if there are more businesses wanting to take out loans they go up. What that means for us is that the rates within risk category are not normally directly related to the likelihood of the business paying back the loan.
Just because one C graded loan is being sold for a 14% return and another is being sold for 11% return does not necessarily mean that the first loan is more likely to default.
In fact apart from the risk category the biggest factor in determining what the rate of a loan will be is the amount of money they are asking for. A loan asking for £5,000 will be filled very quickly. A loan asking for £200,000 will be filled much much slower, because it takes many more investors to get together £200,000 than £5,000.
You can take advantage of this knowledge by simply buying the best value loans.
What we want to do is list every loan that is for sale on the secondary marketplace by the estimated return; by this I mean the gross yield minus the expected bad debt. Unfortunately, Funding Circle doesn’t provide a way to do this, so instead we will need to crack out some primary school level maths.
Head over to the secondary marketplace. We shall set a target for an estimated return of 9%. This means that after the bad debt but before the 1% Funding Circle fee we will need a yield of 10%. We simply add the bad debt rate for each risk band to determine the minimum rate we can accept:
C- : 5.0% bad debt rate, so we need a 15% yield to receive our desired return.
C : 3.3% bad debt rate, so we need a 13.3% yield to receive our desired return.
B : 2.3% bad debt rate, so we need a 12.3% yield to receive our desired return.
A : 1.5% bad debt rate, so we need a 11.5% yield to receive our desired return.
A+ : 0.6% bad debt rate, so we need a 10.6% yield to receive our desired return.
All of these loans fall within our desired rates; in fact at the time of writing there are 132 different loans available.
If we bought all 132 of them each with the same amount of money, our average expected return after fees and bad debt would be 9.3%.
But as we’re sensible and have a strict diversification policy limiting our exposure to each loan at 0.5%, we are still left with 34% of our funds uninvested. But that’s okay, there’s no rush. We can either log on for 5 minutes each week and top up with the new loans available, or perhaps combine with one of the other strategies.
- Very quick to implement
- You will need to log in for a few minutes each week to top up as your loans start getting paid back.
- The 9.3% return, although high, is less than some of the more time consuming strategies.
3. Flip loans from the auction to the secondary marketplace.
Some straightforward arbitrage. Simply you can sometimes purchase a loan from the auction and immediately sell it on for a profit on the secondary market.
All you need to do is make sure the rate you get the loan at auction is more than the current market rate. But how do you know what the going rate is? Simply head over to the secondary market place, sort the loans in your desired risk classification by highest rate, and voilà. Provided the rate of the loan at auction is higher than the highest rate on the secondary market, you’ll be able to instantly sell it on for a profit.
The best part is that you have almost no risk. Provided you sell the loan before the first repayment is due, then there is nothing for the loan to default on. Meaning that we don’t need to limit our exposure on each loan.
Let’s look at an example.
Here I have lent £3,800 at 14.1% with a 1% instant cashback.
Most of the loan was sold at 13.9% with some of it at 13.7%. The whole process took about 10 days.
So what was my return from that 10 day period?
1% cashback up front. Plus 0.5% average sale profit. Plus 0.35% for the daily interest accrued form that 10 days. Minus 0.25% loan sale fees.
Leaving us with 1.6%.
Let’s say you were to repeat this with your entire bankroll once a month. Earning 1.6% a month extrapolates your return through the magic of compound interest to an annual return of 21%!
- Low risk.
- Very high short term returns.
- Most loans don’t finish at a higher rate than the secondary market. In my experience it is more like 1 out of every 20.
- You need to spend a lot of time on Funding Circle as you need to be there and bidding when the auction ends to make sure you get the highest rate possible.
4. Snap up loans that are being sold too cheaply on the secondary marketplace
Most of the time when people put a loan up for sale, they have a look at the marketplace, see what the loan is going for and choose a sale rate around the average mark. But some people just choose a random number. If you’re quick, lucky or have an unfair advantage you can snap up these loans.
You need to be pretty quick though, it normally takes just a few seconds for someone else to buy these bargain loans.
We could sit there all day, refreshing the page waiting, for a bargain to appear, but, luckily we can cheat.
I use this Google chrome app called ‘Page Monitor’. What it does is it will keep checking a page of your choice at set intervals and make a noise when something changes.
Here I have set up the secondary market to show only loans with a rate of at least 14.5% (not including C-) loans. As expected, there are no bargain loans currently available.
Then I have setup the page monitor to make a cuckoo sound if the funding circle secondary-market changes. The only reason the page would change is if there was a new loan put up for sale at at least 14.5%.
Now we can work on other stuff and only head over to Funding Circle when the Page Monitor alerts us. After snapping up the loan, we can either sell it for a quick profit or hold onto it for above average returns.
- Very high relative returns.
- Easy to make a quick buck if you just put it straight up for sale.
- How many bargains appear varies. Some days there may only be one or two, while other days, there can be loads.
- It can be quite stressful, always waiting for the ‘Page Monitor’ to cuckoo at you.
Of the 4 strategies we have looked at, my preference is by far for the first two. I have spent quite a bit of time on the other ones but mainly because I find the concepts interesting, not because I think it is worth my time. The extra level of work required doesn’t suit my size of savings. It’s is only really worth it if you are largely enough rewarded. If you have £10,000 of savings, it is not worth spending a few hours a week extra to turn your 9.5% return into a 20% return. After all, you’ll only make £1,050 extra in that first year.
On the other hand, if you have £1,000,000 of savings it most definitely is worth the time for that extra £105,000. Although, then again, if you have a million quid you probably have much better things to be doing with your time than earning more money.
Just to be 100% clear, I’m not a financial advisor and I’m not qualified to give investment advice. The strategies I have laid out were designed by me for my own use. If you do decide to use of Funding Circle, or these strategies, you do so at your own risk. If you lend money to someone there is a risk of them defaulting so make sure that you do plenty of research outside of this blog before diving in.
* Click on any link with a * for my refer-a-friend link to Funding Circle. We’d each get a £50 Amazon voucher.