P2P Lending’s Idle Money Problem: How Lending Club and Prospers Rates of Return Could be Better

When peer-to-peer lending companies first began originating loans for borrowers in 2006 and 2007, they didn’t do the best job of reviewing their customer’s credit history and the interest rates simply were not where they need to be in order to provide a reasonable rate of return. Since then, Prosper and Lending Club have wised up by limiting who can request a loan, improving their collections practices, and raising interest rates to provide the maximum rates of returns for their investors.

Lending Club states that their investors have earned an average rate of 9.64% APY since the company began offering loans in 2007. This interest rate includes all fees, charge-offs and late-pays. The average interest rate that the company suggests its lenders are returning is accurate, but by the nature of the way the system works, you are very likely to have some “idle cash” sitting in your account balance earning an interest rate of 0, which is not factored into consideration.

Let’s say that you make a $25.00 loan at 11.48%. This means that you’ll get 36 payments of around 88 cents each. Once you receive your first payment, the amount of money that you receive stops earning interest and will sit idle in your account. In order for that amount of money to start earning interest again, you would have to re-invest it immediately. If your cash balance doesn’t meet the $25.00 minimum to make a new investment, you have to put more money in, or wait until your account balance reaches $25.00.

Once you make enough interest to make a new investment, you’ll probably have to wait anywhere from 1 to 2 weeks for the loan to be fully funded and finalized. Only after your loan has been finalized and issued do you start earning any rate of return.

As loans cycle through and investors re-invest the funds that they receive, there will always be some percentage of their investments sitting as idle cash that earns a 0% rate of return. This percentage will vary from investor to investor based on how quickly they re-invest their funds, but it could easily be anywhere from 5-10% of an investors total funds with Lending Club or Prosper.

These two companies could mitigate this problem by keeping customer’s idle cash in a money market fund similar to what PayPal does. This would at least let customers earn 1-2% on their money that’s sitting idle. T

These companies could take an even more innovative approach by allowing its users to allocate their funds to some sort of collective mutual fund that funds loans. This way, their idle cash would be invested for them automatically until they fund a loan individually.

As the P2P lending industry has matured, many have earned rates between 10% and 12% on their money. The true return is probably about 1% less than what’s advertised when considering the problem of idle cash, but P2P investment companies could significantly mitigate that problem by turning unused funds earning a rate of 0% into an active investment.