Tax Efficient Investing Order

When investing on an annual basis, it’s best to fill up your accounts in the following order:

1. Your employer’s 401k/403b up to matching amount
2. Invest the maximum into a Roth IRA
3. Back fill your 401k/403b to the maximum amount
4. Invest in a 529 Account
5. US I Savings Bonds
6. MLP and Muni Bonds
7. Taxable Investments

If you have a spouse, you would also do the same order to their accounts (if all options are available) as you would do for yourself.  Based upon your needs and goals, this order may slightly vary.  The basic gist from this list is to invest first in items that give you the greatest tax reduction or tax delay. Let’s go over the list one by one.

1. 401k/403b up to employer’s matching amount

With a 401k you usually get two forms of “free” money.  Your AGI (Adjusted Gross Income) is lowered which effectively lowers your income at least for federal taxes.  The other factor is most companies match 3-4% of what you invest.   This is the reason to invest in these first and contribute at least up to what the employer matches.  Granted some employer retirement plans suck.  Some plans do not have cheap and indexed based mutual funds (i.e. Vanguard), or have only a limited selection of funds.

2. Invest the maximum into a Roth IRA

As of 2010 the maximum for a Roth IRA is $5,000 per year.  Invest the maximum amount.  Open up an account with a firm that offers low transaction fees like ShareBuilder.  Roth IRAs have quite a few advantages over a 401k/403b or traditional IRA.  A traditional IRA reduces your AGI, but must pay taxes when you withdraw.   A Roth IRA on the other hand, is invested after tax, but withdrawals are currently tax-free.   The other nice aspect of any IRA is the potential to invest in pretty much any type of investment.  From physical gold, to real estate (not REITs!), to Lending Club, and of course more traditional investments.   A Roth IRA is much more flexible than any 401k or 403b.  It’s wise to use IRA accounts to help create a proper asset allocation.  Meaning if your 401k offers a poor choice in mutual funds or doesn’t offer specific funds (i.e. international stocks), your IRA account should be used to fill in that gap.

3. Back fill your 401k/403b to the maximum amount

After filling up your Roth IRA account for the year, you are usually best to go back and back fill your employer’s retirement account to the maximum.

4. Invest in a 529 account

If you have children or have future higher education needs yourself, it’s best to invest money into a 529 plan. Money invested is after tax, but is tax free when withdrawn for qualified higher education.  In some states (New York in my case) gives a state tax deduction for investing.  If you don’t have any needs in this area, you can skip this step.  Unfortunately many parents save for their children first, instead of taking care of their retirement plan first.  Retirement plans should always be funded first since you cannot take a loan out for retirement.  In addition, there are situations in which IRA accounts can use for higher education without penalty.

5. US I Savings Bonds

As mentioned previously, I am a big fan of US Savings I Bonds. I think they are a great way to invest some money that’s indexed to inflation, and yet be tax differed while holding the bond.  They can serve multi-purposes in your portfolio, and can be used for higher education needs tax-free.  At minimum, invest the maximum electronic amount (currently $5000) into I Bonds annually.

6. MLP and Muni Bonds

This is an optional investment as it depends upon your income level, and how complex you want your tax situation.  Though, MLP are a great way to get a steady return, and yet most of it be tax differed.  The disadvantage to a MLP is they are much more complex to deal with when filling your taxes.  It is usually recommend to hire an accountant to properly file your taxes when owning a MLP.

Investing in muni bonds depends upon your income level and the state you live in.  High income (you know the one’s Obama vilify) are usually the best to purchase these bonds.  If you have enough money ($250k+) you can directly purchase these bonds, if not you are best to stick with an index-based mutual fund or ETF to get proper diversification.

7. Taxable Investments

After every other item has been filled, only then it’s time to invest in taxable accounts.  Of course if you have other goals than retirement, and higher education (i.e. buying a house or rental property) you may want to push this item higher up the list.  When investing in your taxable accounts it’s typically best to make sure they are still tax efficient.  This means investing in mostly stocks, ETFs, index based mutual funds, and tax efficient mutual funds.  If you are using it as part of your retirement planning, it should be considered as part of your asset allocation.  This means for example, putting stocks with no dividend into your taxable accounts.

Summary

Keep in mind like any part of investing, one should not invest solely for tax avoidance. Do not miss investment opportunities just because it’s tax inefficient, though it should always be considered with your planing.  Though as your different types of investment accounts grow, you’ll be able to put the new asset class into the most appropriate account.

Related posts:

1. Why I Sold Stocks In My Taxable Account Today
2. Ginnie Mae Investing
3. The 4% Rule to Investing
4. Leave Investing To The Professionals

Here’s the latest performance update for my Lending Club account.  As of today I am earning 11.98% (almost 12% w00t!) annual return on my investment. This is up from my 11.27% return from my last blog post.  I’ve been a Lending Club investor for over one year now.  Since my last Lending Club update, I have added an additional $500.00 to invest.  I had another loan pay off early this quarter.  Also in the past week, I now have a loan that’s 16-30 days late.  From my research, loan defaults peak around 18 months.  So based upon my initial investments from last year I should see more of these.  I’ve been adding notes slowly every month, reinvesting principal and interest into new notes. I’ve been buying mostly B, C and D notes (I have 30% of each).  I’ve been very selective in my note picking, and still sticking with my initial Lending Club strategy.

5 Year Notes

Since my last update, Lending Club introduced 5 year notes.  So far, I’m not impressed with them, and do not see the advantage as a investor.  In my opinion, the average additional 2% interest (for at least the notes I invest in) for 2 more years is not worth it.  You are taking on more risk, for an unsecured loan mind you, and not getting that much return.  As a borrower, I think 5 year loans are a much better deal.  What’s not to like as a borrower? You get a lower rate over a longer period.  So as an investor I’ve been sticking to only 36 month notes.

One Late Note

The current late note it’s the borrower’s first payment Lending Club.  This of course isn’t a good sign.  They previously never had any delinquencies, nor any public records on file, and have a credit history going back to 1994.  The other ironic thing is their FICO credit rating went up the past month from 679-713 to 714-749.  I have put the loan on the block through Lending Club’s FOLIOfn.  So far I do not have any takers and may reduce the sale amount.  The takeaway from this is you never know who’ll become a late payer or default.

Some highlights in my investing for the past three months:

• I now have 89 notes total. Another one paid early.  No defaults and one late payment.
• I added an additional $500 and plan on investing in more notes

Update: As of July 6th 2010, I’ve now reached 12.00% return with my Lending Club investment.

Related posts:

1. Lending Club – Update
2. Lending Club Review – How to Become a Bank
3. The 4% Rule to Investing
4. American Express Merchants Win 10k Promotion

By making smaller calculated bets, that can be somewhat speculative, you might be able to come out ahead.  A proper asset allocation in my opinion is the most important thing to ensure investment success. As I have mentioned in the past, any predictions about the future are like football color commentary.   While the assessments might be correct, it’s sometimes easier to make predictions when you have no skin in the game.

With all of the disclaimers stated, here is my opinion of what I see happening for the remainder of 2010 and 2011.

• US Bond Market – The ultimate be-all bubble.  In the long run, rates can only go higher, but not sure of the time frame.  We will not experience the same low rate for 10-15 years like Japan.  We don’t have savers like Japan does and a big portion of our bond investors come from outside of the USA.  You are best investing in other alternative investments.  Things like Ginnie Mae Bonds, MLPs, dividend stocks, and preferred stocks.  If you do invest in bonds remain on the short end (less than 5 years).
• Unemployment -  It will remain structurally higher for a least the next two years.  This is because of deleveraging of consumers, business and the government.  Tax increases all around and government intrusion into every aspect of business and this is causing uncertainly by small businesses to hire.  States like California cannot keep going at the rate they are going and will need either some sort of Federal bailout or reduce their workforce.  We will not see under 7-8% unemployment during this time.
• GDP – It will remain subdued for the next 2 years at under 3%.
• Inflation – Some sectors are seeing artificial inflation and growth because of government support.  The injected money has to flow somewhere with a 0% FED rate. Hence why you are seeing some disconnect in the stock market with other factors. While it should be higher than the March 2009 lows, it ran up too much, too fast.  The S&P 500 P/E Ratio at the moment is 19.53, while not at the 2000 highs is above the average of 16, so the market overall is not cheap but not outrageously overvalued.  Only a few weeks ago the P/E was over 22.
• Stock Market – The market for the most part will be sideways (moderately slightly higher) until middle of next year.  Volatility will remain increased during this period, so we will have wild swings up and down.  The VIX will remain slightly elevated above historical averages.
• Fed Rate – The Federal Reserve does not raise rates at least until after the election and is expected towards the middle of 2011.
• Double Dip Recession – While not 100% ruled out, it is unlikely based upon the existing growth rate.
• November 2010 Elections – Based upon the tea party movement with the US many people are unhappy with the amount of government intervention.  Expect a big change with incumbents in government.  Expect a pop in the stock market based upon this news either before (because the results will be obvious) or after the election results.

In my overall opinion we’ll see really crappy growth in most of the economy for the next year and half.  My opinions may change over the period of the next year and half, and will revise this page without deleting by striking through the original predictions and listing the revised date.  I will post new tweets on my InvestorJunkie account via Twitter.

Readers: What is your opinion with the economy?  What do you think will happen?

Related posts:

1. Weekend Reading for February 28, 2010
2. 2010 Is Here! Where’s the Monolith?
3. Our 2010 Hyundai Genesis Purchase
4. How Much is 1% Costing You?

As you can see my performance has increased from 10.45% to now an annual return of 11.27%.  Some highlights in my investing for the past three months:

• I sold one note on FOLIOfn because their credit score lowered significantly and was concerned they were going to either become a late payer or default.
• I now have 38 notes total. One paid in full early.  No defaults or late payments.
• I just added an additional $1k this month and plan on investing in more notes

Come June, I’ll be investing in Lending Club for one year.  So far I’ve had great results and been happy with experience.

Related posts:

1. Lending Club Review – How to Become a Bank

Now that you know what is Ginnie Mae, lets talk about these factors:

• What kind of returns should you expect?
• How volatile are they (what’s their beta)?
• What risks do you have when investing?
• How can you invest in them?

Returns

Vanguard's GMNA Fund returns of $10k for the past 10 years (click for a larger view)

Ginnie Mae returns are outstanding when compared to other government bonds.  According to Morningstar, the Vanguard GMNA Fund has gotten an average 6.36% for the past ten years.  The 1, 5, and 15 year returns also show similar returns, so it’s beta is very low. As the graph shows above, if you invested $10,000 in January 2000, you would have almost doubled your money.  This is a perfect investment to add into your security bucket (fixed income) of assets.  At the moment, I have portion of my security bucket into a Ginnie Mae mutual fund.  Ginnie Maes are generating a much better return than other government bonds, CDs and money market accounts.  So you are getting a premium return compared to treasuries, yet getting the same default risk as a treasury.  What’s there not to like about Ginnie Mae bonds?  In my opinion, the rate spread doesn’t warrant the implied increased risk, and are good bet to place in your portfolio.

Risks

As with all bonds, they can suffer interest rate risk, and should always be part of your investment equation.  If the FED increases interest rates, the returns on Ginne Maes could decrease.  They also can have (albeit very low) default risk from the government.  The primary issue is when investing through mutual funds, because not all bond funds are alike.  According to the Washington Post, some Ginne Mae funds invested in other bonds, and got burned during the 2008-2009 stock market crash.  One fund lost over 5% in one year.  Granted, a mutual fund named GNMA legally must invest at least 80% into Ginnie Maes, but it’s the remaining 20% that’s the killer.  I always recommend using Morningstar to do your research.  Find out what other securities the mutual fund invests in, and at what percentage.

Investing

The minimum investment for a Ginnie Mae bond is generally $25,000. You can visit Ginnie Mae’s web site for more information.  Unless you are investing $200-300k to get proper diversification, I wouldn’t even consider that option.  Most people are best suited to invest via a Ginnie Mae mutual fund. The reasons are: better diversification and don’t have to buy/sell the individual securities. In my opinion, the two best funds are from Vanguard and Fidelity:

• Vanguard GNMA (VFIIX) – 0.23% expense ratio, $3000 minimum investment
• Fidelity GMNA Fund (FGMNX) – 0.45% expense ratio, $2500 minimum investment

Both have a low expense ratio, consistent performance, and a low minimum deposit requirement.  There are many other GMNA mutual funds available.  Do your research on Morningstar for others.  Currently there isn’t a Ginnie Mae ETF, and mainly because there isn’t an index to base the ETF upon. With active ETFs becoming more common, I suspect a Ginnie Mae ETF might be on the horizon.

Disclosure: I own shares of FGMNX.

Related posts:

1. The 4% Rule to Investing
2. Morningstar Review
3. Lending Club Review – How to Become a Bank
4. Review of “The Investor’s Manifesto” by William Bernstein

MLP is NOT My Little Pony!

What is a MLP?  It is NOT My Little Pony as what came up when I was Googling for this article.  MLP in the investment world means Master Limited Partnership.  MLPs have generated some of the best returns for the past decade, and yet it’s a secret to most investors.  I myself only found out about them two years ago. They are publicly traded and you can purchase one on many of the security exchanges.  MLP’s combine the tax benefits of a limited partnership, with the liquidity of a publicly traded security. It is known to some as a granny investment;  they generate steady income, can appreciate like a stock, and have good tax benefits.  I happen to love them since they are very similar, in tax advantages, to owning your own business.  Master Limited Partnerships are limited by US tax Code to only apply to enterprises that engage in certain businesses, mostly pertaining to the use of natural resources, such as petroleum, natural gas extraction and transportation. Some real estate enterprises may also qualify as MLPs.  In addition, some private equity management companies such as the recently gone public, Blackstone Group (BX) and Fortress Investment Group (FIG) are structured as MLPs.  Many MLPs generate 7 – 8% dividend yields, and most is tax-deferred.  For many large master limited partnerships, 70% or more of their dividends are tax-deferred.

What are the Advantages of a MLP?

• High consistent distributions make MLP average yield in the 8% range
• MLPs have constantly increased their distributions over time.
• MLPs have a low correlation to bonds and stocks, which makes it perfect in your asset allocation mix.
• The corporate structure makes it a favorable tax treatment and avoids double taxation.

Tax Advantages

MLPs have a big tax advantage compared to stocks with dividends and other assets classes. It’s a perfect investment to put into taxable accounts. While you can put a MLP into a retirement account (such as an IRA) it is not recommended because of the tax complexities.  With MLPs, you should practice a buy and hold mentality because of the tax implications.  When selling a long-held MLP the cost basis can be high because of the many years of dividends (they are really distributions).  With a MLP you do not get a standard 1099 form, and get a K-1 tax form instead. Unlike dividends, these distributions are not taxed when they are received; instead, they are considered reductions in the investment’s cost basis and create a tax liability that is deferred until the MLP is sold.  Because of this deferral, unit holders often pay an effective tax rate of under 10% of annual distributions. Depending upon your tax situation, this rate can fall as low as zero in some cases.

MLP Stocks

Here is a partial list of MLP stocks.

• Boardwalk Pipline (BWP)
• Enbridge Engergy (EEP)
• Enterprise Product Partners LP  (EPD)
• Kinder Morgan Engergy (KMP)
• Magellan Midstream (MMP)
• Plains All American (PAA)

In Summary

For anyone who’s looking for a a steady income and nice tax deferral, a MLP might be something you want to add to your taxable portfolio.

Disclosure:  I own shares in PAA.

Related posts:

1. The 4% Rule to Investing

Why Own Gold?

Adding gold to your portfolio should not be thought as traditional investment compared to stocks. After all, when was the last time a piece of gold bullion gave you a dividend? Gold should be thought as an insurance policy.  Do not look at purchasing gold as a method to get rich.  It’s a method to help hedge against inflation, deflation, or uncertainty with government policies.  With fiat currencies which are printing more money than ever, the repercussions could be dangerous.  Right now we do not have the velocity with money, so therefore inflation is currently at bay.   The Federal Reserve assumes they can remove the cash quick enough when our economy picks up.  It can be said the Federal Reserve kept previous rates after 9/11 too low for too long, and where a primary member in causing the sub-prime crisis.  The Federal Reserve also missed the crisis itself.  What makes people think the Fed will be able to properly land this airplane?

Gold’s essential quality it’s not someone else’s liability or asset. That separates gold from the majority of capital assets rely on someone else’s ability to pay, like bonds and bank savings, or the performance of the management, or some other delimiting factor, as is the case with stocks.

Asset Allocation

How much gold should allocate to my investments?  The typical allocation of commodities should be no more than 3 – 10% of your total portfolio. I recommend some physical holding of gold, and should be no more the 1-3% range.  Plus, they are also nice to look at .  With owning gold coins or gold bullion, you have to concerned where to store it safely and insuring it.  You have a number of options: safety deposit box, hidden in the ground, in your own safe, or with a holding service.  Gold is a small market comparative to other markets like the NYSE so pricing can vary quite a bit daily.  For past few months we’ve seen wild swings of of up or down $25+ USD per day.  I recommend with any commodity to dollar cost average, and buy on the dips.

Where to Buy Gold Coins?

Special offer to Investor Junkie visitors. Get $25 off orders over $150 with GovMint.com

You can buy online, or your nearest numismatic store.   For online, I’ve great results with APMEX, their prices are good and their service has been great.   For a local store in Long Island, New York, I’ve had good results with Eastern Numismatics Inc.  They are based on Long Island, but they also have a web site to purchase online.  When purchasing coins they are typically 3-6% over the spot price of the raw material.  This is because of the cost to create of the coin, transport and middleman fees.

Taxes

What happens when I sell bullion?  Unfortunately the US government considers coins as a collectible, and is taxed at your income rate, not long term capital gains (like stocks).  For this reason I plan on holding my coins for many years and maybe even pass down to my heirs.

Is there a gold bubble?

Maybe.  It’s a little concerning when you can buy gold plated Sony PS3 game consoles, and every other commercial on financial news sites mention owning gold.  For me, I’m a long term (10 – 20 year) investor, and based upon the macro economic policies gold will go higher.  For the short term (next 6 – 24 months) it’s possible it will go lower.  Silver is an alternative to gold, and might be a better option for the short term as the ratio to gold/silver is at historic highs.  This means one of two things could happen, either gold is way over priced, or silver is under priced.  I believe silver is under priced at the moment, with long term trend going much higher.  Silver is used more than gold for commercial purposes.  In the end, I believe it’s wise to own both commodities.

Disclosure: I own gold coins and have investment in gold in our retirement accounts.

Related posts:

1. The 4% Rule to Investing

As of right now, Fed rates are expected to stay this low for a good portion of 2010.  I’ll even go out on a limb and state these traditionally safe investments, with their current rate of returns, are not safe.  Rates are artificially low, and can only go higher from here.  In the long run, any of these investments run the risk of not keeping up with inflation.  Inflation risk is a real issue, that’s rarely mentioned when investing.  Inflation for the previous 30 years has averaged 3.28%, and it’s a good chance to be higher for the next 30 years.  The Federal Reserve is punishing savers/investors, to help debtors, and that’s a topic for another discussion.

So what’s the 4% rule?

I consider this as part of my security bucket of investments.  These are investments that have a low beta, but yet generate monthly income.  I have this rule because of the tax man, inflation and expenses quickly eat at your return and can make your return effectively zero.  If expected returns are lower than this, in my opinion, you are best not investing in that asset.  If you have a 5+ year investment horizon, you should get much more sizable returns on your investment.  Any investment goal of less than 5 years should be only put into fixed rate investments, even if less than 4%.  The goal is to prevent having to take the money out of the investment at an inopportune time.  Money invested should be used for the ultimate goal to increase cash flow and should not be needed for any short term goal.  My investment horizon is always 10 – 20 years and something I’ll discuss in future blog posts.

One of the basic rules of investing: The higher return, generally higher the risk.  Depending upon the investment, there are things you can do to mitigate risk, but the general rule applies.  For the past 100 years the return of US stocks has averaged 8%.  With your investment, you may do better or worse, but is your top line goal.  Annual investment returns above 8%, while possible, the odds become stacked against you.  Getting somewhat safe returns of above 4% isn’t difficult, and should be the goal you shoot for.

Investments Options

The government is forcing investors, on purpose, to put their money into riskier assets.  The question becomes, what other investment options are available that offer higher returns, yet are not as risky as say stocks?  Since traditional fixed rate investments are earning nothing, what other alternative investments are available?

• Peer-to-Peer loans.  See my Lending Club Review
• Ginnie Mae bonds
• Master Limited Partnerships (MLP)
• High interest savings
• TIPS and I-Bonds
• Corporate and junk bonds
• Muni bonds
• High dividend stocks
• REITs
• Whole life insurance
• Debts owed

Each can and will be a future blog post discussing each in detail.  Like the song, “Which one of these is not like the others?” It’s the last one of course. Any debts you may have are not traditionally thought of as “investments”.  Benjamin Graham mentions in “The Intelligent Investor”, like a scale, investments are always compared to other possible investments.  Although debt owed is not discussed, I believe it should also count.  For example, if you have a credit card rate that is 8% or greater you should pay off that debt first before adding additional investments to your portfolio.  It’s a guaranteed rate of return that’s hard to beat.  It becomes hard to find investments that can consistently beat 6-8% year after year.  If you find something that will, go for it, but the odds are stacked against you.  Home mortgages, because of their tax deduction, can have a higher APY (8-10%) before pre-paying.  Bankrate.com has a great calculator for your mortgage interest rate after taxes and use that as a guide for the number to beat.

The questions you have to ask with any investment:

• Can I get a better return somewhere else?
• Does that investment have a similar or less volatility?

As the Federal rate increases so will the traditional investments in: CDs, government bonds, and money market accounts.  Once their returns go above the 4% annual rate I will consider them attractive investments again.  For now, I am placing money from my security bucket into alternative investments.

Related posts:

1. Lending Club Review – How to Become a Bank

What Happens When Buying a Timeshare

My wife and I went on vacation this past October to Disney World.  The family had a great time and I personally was glad to get away from business.  We stayed at my parents Orange Lake Resort timeshare, which is just outside of of Disney World.  In the over 10 years they have owned it, this is the first time I went there.  I never agreed with them on their purchase, and always thought it was a bad decision.  After all they paid $10,000 for it, and today the maintenance is $750/year.  The resort itself is very nice, has all of the amenities, and is in a great location.  My question is wouldn’t it be cheaper to just stay at a hotel, or better yet rent a unit in the resort for that week?  The answer is unfortunately yes.

In order to get “free” tickets to Universal Studios and SeaWorld I had to go with my mom to their sales presentation.  “Shamu, Shamu, Shamu!” as my son said at SeaWorld.  I certainly was Shamued!  I’d like the 2 hours back that I spent listening to the high pressure sales pitch!  I guess they figure if you were dumb enough to initially purchase one, hell why not go for two?  That in my case, the genetic pool must be the same, and I would also succumb to the same decision.  I would have rather paid for tickets, then wasted my time listening to them blather on and on.

My parents timeshare is one of the older ones.  You buy a specific week and can only use it during that same week every year.  If you want to go at another time you must “bank it”, and exchange it for another time or location.  In the sales pitch they mentioned they are no longer doing week based timeshares.  It’s now a point’s based system.  You get X amount of points per year when you buy a unit, and can then use it any way you choose.  The points could be used instead for many other things: purchase airfare, go to another location, or upgrade to a bigger unit.  Heck, like airline miles and credit card points, you can use them in stores like Best Buy or Bed, Bath and Beyond.  Great I can buy that toilet seat cover, instead of going on vacation.   I’m sure just like credit card points you are getting a fair exchange of points into dollars.  If you don’t detect it, I’m being sarcastic.  I didn’t run the numbers, but I’m sure the conversion rates are awful.  So in the end, they are making timeshares a much more abstract than a hard asset to own, even one week of it.  High pressure sales guy please remind me again what’s the purpose of owning a timeshare?

Unfortunately I think the timeshare market targets the financially inexperienced and lower income brackets.  Their sales material make it appear more about the bling and leading the good life, than about the investment return.  That’s because there IS no return.  If you are outlaying money for the future, it should be considered an investment.  If it’s not generating income, it’s an expense plain and simple. You MAY get enjoyment out of it, but it’s still not an investment.

It’s been said in poker if you can’t spot the patsy, it’s you.  This applies to purchasing a timeshare.  The ones benefiting from the transaction are the sales person and the owner’s of the resort.  You unfortunately are stuck with a small slice of a unit that has little resale value.  Here are the issues:

• There is a HUGE reseller market.  Often you can pick up units for less than half of what was originally paid for
• Like buying a car, it depreciates once you drive the timeshare off the lot
• It’s rare a timeshare increases in value
• Timeshares are usually hocked when you are on vacation, and your defenses are down
• Most have high yearly maintenance fees. In my parents case it’s increasing every year faster than the rate of inflation.  For the amount that you pay in maintenance fees alone (forget about the initial “investment”), you can stay at a nice hotel.

There are many online web sites where you can buy a used timeshare.  If you still think buying a timeshare is a good idea, buy one on the secondary market.

No related posts.

UPDATE: Lending Club Performance

Did you ever wish when applying for a bank loan, that you were the loan officer sitting on the other side of the table?  Well now you can with peer-to-peer (P2P) lending services like Lending Club.  They offer a higher rate of return (over 9.6%) than many other traditional investments and you have some ability to manage risk.  It’s similar in class to bonds, but is more like if you owned a bank and were the loan officer.  You determine which loans you want to approve, and which ones to pass on.  Sounds interesting?  Keep reading for more details.

Borrowing from Lending Club

Loan applicants visit LendingClub.com and apply online.  They must have a FICO score of above 660, which is above the subprime loan category.  Over two-thirds of applications get rejected by Lending Club, so only a small sub-set of individuals get approved, and is part of the risk management they perform.  Borrowers can apply for a loan from $1,000 to a maximum of $25,000.  The interest rate is determined by Lending Club and based upon the applicant’s credit rating.  The interest rate and term is a fixed 3 year loan, and currently do not offer any other loan terms.  All loans are unsecured lines of credit and no different than credit card loans.  Also like credit cards, any defaults are reported to the three credit rating agencies (Equifax, TransUnion, and Experian).  For more of a borrower’s point of view, visit the web site DebtFreeAdventure.

Investor Requirements

Since this is a blog about investing, lets discuss how to get started. Do you meet Lending Club’s investing requirements? Here are the requirements:

• Income Level – In most states, you must have a gross annual income of $70,000 or more and have a net worth of $70,000 or more.  In the state of California, investors must have a gross annual income of $100,000 and a net worth of $100,000.
• Approved States – You can invest if you are you a resident of: California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Kentucky, Louisiana, Maine, Minnesota, Missouri, Mississippi, Montana, New Hampshire, Nevada, New York, Rhode Island, South Carolina, South Dakota, Utah, Virginia, Washington, Wisconsin, West Virginia, and Wyoming
• Net Worth – If your total net worth is great than $250,000, there is no annual income requirement.  In the state of Kentucky, investors must qualify as an “accredited investor” under the securities act.
• Asset Allocation – Lending Club investors must not deposit more than 10% of their net worth in Lending Club notes.
• $25 – Only $25 is needed to start.   If you sign up now with Lending Club they will give you an additional $25.

The sign up process as an investor is simple and takes a few minutes.  You can fund your account either via an electronic transfer from your bank, mail in a check, or for instant availability use PayPal.  In my case, I choose PayPal to fund my account, so I also get credit card points.  Once setup, Lending Club has the requirement you must invest at least $25 per note.  Notes are graded from A1 (lowest risk/lowest rate) to G5 (highest risk/highest rate), with sub grade per rate.  As of December 7th, 2009 the rates are as follows:

Once you review and pick a loan it will take a few days before it’s completed.

Investing Strategy

Scott Langmack of Peer Lending Wealth, has an interesting perspective on how to maximize your return, yet minimize your risk.  To summarize his info:

• Look for someone who has a job for a long time (10 years+ being ideal)
• Hold some sort of government position
• Has a low debt to income ratio.
• Go for primarily people looking to pay off higher interest rates, than the more riskier types of loans (like new business)
• Build up a portfolio of at least 200 notes.  The more notes, the more even your portfolio’s performance.  This helps spread the risk out to many loans, should one default.  This then means a recommended minimum of $5,000 to invest.

Let me add to Scott’s recommendations.  First of all, like Scott, I do not use Lending Club’s automated investment tool.  I manually select the notes I wish to fund.  I filter my selection of notes by the following:

• Loan Purpose – I tend to focus customers looking to get a better rate and reducing their debt
• Minimum Length of Employment – greater than 1 year.  The longer the employment the better
• Maximum Debt-to-Income Ratio – 30%
• Credit Score – greater than 678
• Interest Rate – All.  Though I trend towards selecting the higher rates.  You should own a mixture of loan grades to help increase returns.
• Delinquencies (Last 2 yrs) – none
• Reviewed by Lending Club – Yes. I preferred lending club has checked them over.  It gives a better chance the loan will complete and information is legit.
• Verified Income - Yes.  At least as the initial filter.  I also look at unverified income applications.

While I do make exceptions to the filtering, I tend to look at the big picture.  The question you should always ask, “Will the individual pay back the loan?” and “Are they a good credit risk?”.  If you have any doubt in an application, skip it and find a better one.  If currently no good application exists, wait a few days and check again.  There is no need to rush the process and take your time picking what you consider the cream of the crop, then getting stuck with a bad note.  Lending Club themselves has plenty of statistical information and so does LendingClubStats.com.  Analyzing borrowing trends is something I recommend.

Secondary Market

Should you want to unload a loan, there is a secondary market from FOLIOfn.  This is great if you have an bad performing loan or need cash for other investments.  It’s also a great way to pick up notes from others selling.

Possible Risks

With any investment, even “secure” ones, you have risk.  In summary here are some possible risks with investing in Lending Club:

• Investments are not FDIC insured
• Similar to bonds since it’s a fixed rate, you have the risk of inflation eating at your returns.  Though at the high rate of return, this is minimized.
• Lending Club’s yearly fee is 1%, this rate has already increased from I believe the initial 0.5%.  This fee could increase in the future.
• Loans can be paid in full early and affect your return.  The downside is you will need to find another loan to replace it.
• The SEC filing shows Lending Club invested $2.4 million from October 2008 to March 2009 to co-fund loans.  This represents 24% of loans funded during that period.  What happens to new loans if Lending Club does not invest?
• If you have a small amount of loans, (under 100) one default can dramatically affect your overall return
• Lending Club will properly price the borrower’s risk to default.

With the last issue, you can minimize this risk by specifically picking the loans you want to fund.  You don’t think it’s a good loan? Don’t invest in that note.

Taxes

Lending Club investments are NOT considered passive investments by the U.S. Government.  This means you cannot get long term capital gains tax rate.  Therefore the IRS taxes any profit as ordinary income (unlike stocks).  Lending Club investments might be best suited to a Roth IRA retirement account.  I currently have my investment in a taxable account, but Lending Club does offer IRA accounts.  To open an IRA a $15,000 minimum is required.

Current Results

I started with Lending Club this year (May 2009), and put $1,000 ($925 deposited, $75 in sign-up bonuses) into my account. As of today, my current performance is 10.45% with 24 loans.  I have it as a small part of my security bucket.  Believe it or not, my performance from my peers in Lending Club is in the 39 percentile, not great and I hope to increase in the next year, with better note selection.  The average return is 9.67%, and I’m in that most common grouping.  I currently have no defaults, and monitor my loans closely.  Based upon Scott’s results, defaults tend to increase up to the 18 month mark and quickly decrease after that hump.

For next year my goals are:

• Adding an additional $2,000, with the final goal of $5,000
• Invested with 100+ loans.
• Perform this over a three year period and invest a little at a time.  This allows me to closely watch my returns, and smooth out returns at the same time.
• Searching the secondary market (FolioFN) more for any good loans to acquire.

Disclosure: I have $1,000 invested into Lending Club loans.

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