[The last post described the general concepts and issues with peer-to-peer lending. If you’re coming here from a search engine then you should read that post before you start plugging numbers into the calculator. You may decide that there’s a better way to pay off debts than a peer-to-peer loan.]
Welcome to the peer-to-peer loan calculator!
This blog doesn’t talk about debt very much. If you’re pushing hard to reach financial independence then you probably left debt in the dust long ago and you’re saving at least 20% of your income. However, this post is part of a series on P2P lending, and about the only reason that people become P2P borrowers is when they don’t have enough money. Maybe they were ambushed by a large expense (with perhaps a high interest rate), or maybe they’ve spent more than they earned.
If you’re thinking about borrowing money from a P2P lender then you’ve already decided that this is your best choice of a very limited range of financing options. If you’re considering lending money through a P2P company then this is your chance to see how your prospective borrowers are thinking.
Before we go any further, let’s figure out whether you’re wasting your time with these lenders. Here’s what Lending Club wants to see from you:
- a minimum FICO score of 660;
- a debt-to-income ratio (excluding mortgage) below 35%, as calculated by
- the debt reported by a consumer reporting agency; and
- the income reported by the borrower;
- a minimum credit history of 36 months with
- less than seven inquiries in the last six months, and
- at least two current revolving trade accounts.
In other words, you need to have at least a 660 credit score. Your current debt-to-income ratio can’t exceed 35%, but Lending Club will excuse your mortgage from that ratio. You also have to have at least three years of credit history (with other loans or credit cards). That has to include at least two accounts that are current (not delinquent) and your credit report can’t have more than six other inquiries on it. If you’ve been late on your credit card payments, or if you’ve applied for a bunch of other loans, then you may be out of luck with Lending Club for a few months.
No Lending Club? No problem! Here’s what the Prosper prospectus expects:
- a minimum FICO score of 640, except for Prosper second-time borrowers who may have a score as low as 600.
Um, that’s it for Prosper. The company is seeking a much wider variety of customers, but Prosper’s riskiest loans will charge very high interest rates. There are very few minimums for the Prosper application but your credit report and your debt-to-income ratio can still reduce your qualification score (and raise your loan’s interest rate). Prosper is not flinging buckets of money at its borrowers– they’re simply expecting their lenders to do their own due diligence.
Note that both P2P lender websites will expect to see some income. In other words, you should have a job. (If you have enough income from other assets to afford to make P2P loan payments, then perhaps you’d just cash in those other assets and pay off the credit card without the P2P loan.) Your interest rate will be set by the debt-to-income ratio that’s calculated from your salary, so you’re going to earn your way out of this debt problem.
Lending Club and Prosper do minimal diligence on your application. It’s more than a credit-card application or a payday loan company, but it’s far less than a bank loan. The P2P lenders will verify your identity and do a credit check, but that’s about all they can afford. Neither of these companies is profitable, and only Lending Club has had a quarter where revenues exceeded expenses.
This means that both companies base much of their screening on the information you provide. They could ask for verification, but that costs time & money. They may have a few “lie detector” software tools to help them review your application, but they’re largely depending on you to tell the truth. You could be tempted to pad your “stated income” with a little-anticipated overtime (or the revenue you expect to earn from your blog), but don’t even start down that road. Tell the truth and don’t enhance your profile. (If you lie on the application, that’s considered “fraud”.) Their screening process may only give you one shot at your loan and no flexibility on your interest rate. Answer questions as promptly as you can and don’t even quibble with the truth. Remember why you’re applying for a P2P loan: because you’ve decided that you’re nearly out of alternatives.
You’re almost ready to start tinkering with the calculator.
P2P lending is an evolving business, and the two major U.S. companies are constantly tinkering with their models. The information that you’re plugging into the calculator comes from their prospectus and their websites, but the two sources may occasionally vary from each other. (I’ve had to go from their websites to their prospectus to their blogs to confirm some details.) If you spot an error in this post, please point me to the new information and I’ll update my links.
The calculator will let you enter any numbers you want, but here’s what you can get from the two P2P companies:
- 36-60 payments (Loans from $1,000 – $15,975 are limited to 36 payments.)
- APRs from 7%-27%
- 36-60 payments
- APRs from 7%-35%
Note that your loan interest is expressed in terms of APR, not “interest rate”. Part of the reason is that the companies charge an origination fee which is subtracted from the loan amount before they even give you the money. Although you borrowed an amount at a certain interest rate, you’re repaying a smaller amount for longer than one year. The equivalent annual interest rate that you’re paying is required by law to be expressed as the APR so that you can compare one loan’s APR directly to another.
This P2P loan calculator will give you an estimate of your loan payment. It helps you decide whether you should try to pay (1) a higher monthly amount for a shorter-term loan at a lower interest rate rather than (2)a lower monthly amount for years at a higher interest rate. Once you see how these payments affect your budget, you may decide that you can’t afford a P2P loan. Because of the origination fee and the APR, this calculator may produce slightly different numbers than Lending Club or Prosper. If the monthly payments are within $10 then you’re probably fine. If the monthly payments are different by more than $10 then check your loan amount, interest rate, origination fee, and APR.
Let’s walk the calculator through an example.
Assume that you’re paying 27% interest on your $10,000 credit-card debt. I chose that number because a 27% APR works out to about 2% monthly interest on that $10K, which means that it’ll cost you just over $201/month to tread water. (American Express also tells me that if I’m a day late on a payment, they’re going to jack me right up to that APR.) Even if you cut up your credit card (no more charging it!) and can afford to pay $300/month toward that $10K balance, it’ll still take you years to pay it off. Most of your $300/month payment is eaten up by the interest.
What if you can get $10K for three years from a P2P lender at 20%? According to the Lending Club and Prosper websites, that’s a lower APR for a higher-quality borrower. You’d only have to endure the payoff pain for 36 months and you’d pay less interest. But could you afford the higher monthly payments to apply for a P2P loan?
Click on the link below to the calculator and enter the following data:
- “Loan Amount” as $10,000.00
- “Down Payment” is 0
- “APR” is 20
- “Number of monthly payments” is 36.
Now click on this link to FinancialMentor.com’s Personal Loan Calculator.
Your calculated new monthly payment is $371.64. However, you remember from reading the last post that the P2P lenders are going to deduct 1%-5% of the loan amount when they fund it, so you’re going to start out by borrowing just $9500-$9900. If you re-enter the data into the calculator assuming that the 5% fee leaves you with a $9500.00 loan amount, your payment drops to $353.05. Unfortunately, you’ll still have to cough up another $500 of your own money over the next 36 months to finish paying off that credit-card balance at a 27% APR, so that’s roughly another $14.25/month out of your pocket. $353.05 + $14.25 is still $367.30, not too far from the original $371.04 payment.
If you decide to completely pay off your credit card balance by borrowing $10,526, then even at a 5% origination fee you’ll at least have $10K left to send to the card company. In other words, you just paid over $500 to a P2P company to let them “award” you a lower interest rate. You can re-enter that $10,526.00 number into the calculator to determine that your monthly P2P payment will be $391.18. Oh, and now you’re deeper in debt because you borrowed an extra $526.
Let’s take a look at your budget. You had to pay $201/month just to breathe air on your credit-card APR of 27%. If you were paying $300/month then you’d pay it off years later, and that payment might still fit into your budget. Could your budget still survive if you had to pay nearly $400/month? Sure, your APR dropped from the card company’s 27% to the P2P company’s 20%, but you had to squeeze the repayment into 36 months (instead of years). Are you sure you can you handle $400/month?
What if the interest on your $10K credit-card debt was “only” at 13%, and you could borrow the P2P money at “just” 7%? A 13% APR works out to about 1% per month, so your monthly interest payment to the credit card company would be $102.
Try the calculator again:
- “Loan Amount” as $10,000.00
- “Down Payment” is 0
- “APR” is 7
- “Number of monthly payments” is 36.
This time your monthly payment on a $10K loan amount is “only” $308.77. Once again you’re paying more than your credit-card company is asking for because you’re paying off the loan in just 36 months, not several more years. You’re also paying the P2P company a 1%-5% fee for the privilege.
This is a hard choice. (Probably because both alternatives suck.) By lowering your interest rate, you pay a lower total amount. However, by shortening the length of the loan, you pay a higher monthly payment. That’s no problem if you have the room in your budget, but if you have to cut back on other spending to pay your P2P loan then you may be putting your finances under even more stress.
Let’s step back from the lending mechanics and the debt payment calculators for a few paragraphs. Take your hands off the P2P website’s fascinating buttons & levers and think about the big picture.
Remember from the last post that you also have to change your spending behavior. Not only do you have to pay off that higher P2P monthly loan amount, but you also have to quit spending more money than you earn and begin a new life of financial responsibility. We’re not just talking about cutting out your daily Starbucks run. This will require no more use of your credit cards, no more fantasy vacations (for up to three years), no new outfits (unless you’re at a thrift store), and maybe even eating out just once or twice a month. The “good” news is that with a P2P loan you only have to put up with your new lifestyle for three years. The “other” news is that you had to pay The Man the P2P company a fee to even get you started on this enforced accelerated payoff.
Let’s re-examine that lifestyle question for a minute. What if you can negotiate a raise with your boss? What if you started a side hustle (like, say, blogging) to raise your passive income? What if you could share your lodging with a roommate and reduce your mortgage or your rent payment? What if you lived close enough to work to be able to ride the bus or a bicycle instead of using your car? What if you even (*gasp*) learned to live without your car and sold it? If you’re able to take these big, bad, bold financial steps then you’re no longer agonizing over whether to pay $200/month or $400/month on your credit-card debt. Instead of going to a P2P lender, you’d redirect your new lifestyle earnings & savings of at least $500/month straight to the credit-card company. You’d be debt-free in less than three years. The reality is that you’d be saving a good bit more than $500/month, and you’d probably be debt-free in under two years. Shucks, if you sold the car next week then you’d be debt-free in a few months.
Yeah, I hear you. Too hard. Ain’t got no time fo’ dat. Crosses the line from “frugality” to downright “deprivation”. You’d go nuts. Your spouse & kids would never put up with it. Your friends would tease you.
Well, just how good is your life right now, lugging around that $10K debt ballast? How much of your time do you spend worrying about your debt? How much better would your life be if you were swapping one debt for another and actually making a higher monthly payment? If you could implement even more radical cost savings in your budget then you’d be out of debt even faster, and afterward, you could use your new lifestyle to accelerate saving for your own financial independence.
Remember, the reason that most people are considering a P2P loan in the first place is that they haven’t saved their own money. They may even be spending more than they’ve earned. Although a P2P loan could “solve” their short-term debt problem, the only thing that’s going to permanently solve their lifestyle problem is a new set of behaviors.
P2P borrowing looks like a good deal. Instead of paying ludicrously high interest to a faceless monolithic credit card MegaCorp, you’re paying slightly less interest to real people who are willing to take up a collection to help you get your life back on track. It’s very tempting, and the social proof of all those lenders is a warm & fuzzy feeling. But if you miss one of those P2P loan payments, or even come in a little late, then you’ll be facing a very different sort of peer pressure.
I’ve used the math of P2P lending to show you that it can get you out of serious debt trouble by forcing you to cut back to a shorter repayment schedule with higher payments. But if you can modify your budget to meet those higher payments, then why pay someone else to help you modify your life? Why not modify your life even more? The “old” version of you would have paid off the P2P loan, heaved a huge sigh of relief, and returned to your old lifestyle. Maybe you would have put that $300-$400 into your financial-independence account, but you haven’t really changed your behavior– you just forced your peers to change it for you.
However, if you take the extra steps to really cut your spending (or possibly boost your income), then you’ll pay off your debt even faster than the P2P loan terms. Not only that, but it’s tremendously empowering to watch that debt balance melt away like an ice cube on a hot sidewalk. You’ve accepted the challenge of getting out of debt, but you’re not just paying a P2P lender to living under their rules. You’ve taken charge of your own life and your own spending, beaten your debt into oblivion, and freed up serious money to save for your financial independence.
Are you really sure you still need to be a P2P borrower? Do you really need to pay someone else 1%-5% of your debt to help you get out of debt? Would you like to develop your own financial muscles to keep saving for financial independence after you finish paying off the debt?
You’ve seen what P2P borrowing can do for you– but I hope this post has shown you that you can do even more for yourself.
The problems with peer-to-peer lending (the first post of this series)
More problems with peer-to-peer lending (the third post of this series)
Financial Mentor’s credit card minimum payment calculator
(See what paying $750/month on that $10K credit-card debt would do for you.)
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