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3 Passive Income Investing Strategies Explained

How to create passive income with three of my favorite investing strategies

You wake up, you work, you go to bed. You wake up, you work, you go to bed.

Sound familiar?

I don’t claim to have solved the meaning of life but I’m pretty sure we weren’t meant to work our lives away. And unless your numbers come in or a long-lost rich uncle leaves you a few million, you need to find a way to free you from the work-a-day rat race.

Enter passive income.

Since 2013, I’ve been creating passive income sources that have not only supplemented my income but eventually grew to replace it. Some of the income streams have grown from online businesses like self-publishing, blogging and running a YouTube channel. Others have grown from my three favorite investing strategies.

It’s those three passive income investing strategies that I’m going to reveal in this article. Not only will I explain each but will show you how I’ve used them to create an income stream of $3,300 a month that I can count on whether I work or not.

It’s time to make your money work FOR you instead of always working for your money.

Dividend Income Investing Strategies

Dividend stocks are by far my favorite investing strategy. Stock prices rise and fall, and sometimes that fall is excruciating, but the dividend payments you get from your investments are always a positive return.

Not only do dividend stocks pay you while you invest but the group has been shown time-and-again to beat the market in total return. In research by Ned Davis, dividend stocks returned between 7.2% and 9.5% on an annual basis compared to just a 1.6% annual return on stocks that didn’t pay a cash yield.

Passive Income Dividend Stock Returns
Passive Income Dividend Investing

The dividend income investing strategy does even better when the stock market crashes. Other research shows that dividend stocks see about half the volatility as other stocks during a crash and share prices tend to hold up better.

That’s a big part of the reason our 2019 Stock Market Challenge portfolio has beaten the market so far this year. I invested $1,000 in 10 dividend stocks on M1 Finance in January, ten quality stocks with high dividend yields. Five months into the year and the portfolio has jumped 20% versus a return of just 14% on the stock market.

I’m using M1 Finance for a no-fee investment approach and opened an IRA account on the platform so I don’t pay taxes on the dividends each year. The platform is my favorite in no-cost investing and offers all the tools I need to create a long-term portfolio.

Learn more about M1 Finance and no-fee investing here

I recently added a few crash-proof dividend names to our 2019 challenge portfolio including one that has already jumped to a 30% return.

I make just over $900 a month across all my dividend investing portfolios. One of the keys to making so much from this income investing strategy is REITs and MLPs.

REITs are real estate investment trusts, a special type of company that holds commercial rental property. The companies get a special tax break if they return 90% or more of profits to investors. That tax break means a cost-effective way to hold real estate and huge dividends for investors.

MLPs are master limited partnerships, another special type of company that holds energy infrastructure like pipelines and storage facilities. Just like with REITs, these companies avoid paying corporate taxes if they return profits to shareholders.

Besides that special tax break that helps these companies outperform, there are two reasons I like MLPs and REITs. First is that many pay monthly dividends. I don’t have to wait for my dividend check each quarter. That makes it much easier to plan a passive income stream when I know I can expect money each month.

The second reason is that these are some of the highest-yielding stocks you can find. I average a 6% dividend yield on my portfolio of REITs and MLPs, three-times the average yield on the broader stock market.

There are some things you have to understand about these monthly dividend stocks, like you can’t value them with normal measures like price-to-earnings. You also don’t want to depend on these for your entire portfolio and I’ll tell you why in this video.

best dividend investing books 2017

If you want to learn more about income investing including how to create a monthly dividend check from four income sources, check out Step-by-Step Dividend Investing. In this quick guide, I walk you through my favorite dividend investments and how to put together a portfolio that pays you to invest!

Real Estate as a Passive Income Investment

I got my first real break in real estate investing. I landed an internship as a commercial property analyst during my last year of college and immediately fell in love with this income investment.

No other investment has created as much legacy wealth as real estate. Every single person on the Forbes Billionaire List has real estate investments and many built their fortunes in property.

After college, I started buying rental properties and flipped real estate before I became an equity analyst. I’ve been in just about every type of investment and can tell you, you get a feeling of pride from owning physical property that you don’t get in anything else.

While I’ve scaled back my real estate investments over the last few years, I still own rental property and a partnership in some commercial properties. I earn a $2,400 monthly income stream off the investments and spend almost no time managing the portfolio.

The problem with real estate has always been the high cost to get started. Even with FHA and VA loan programs, buying a rental property can cost tens of thousands down. There are some strategies you can use to start investing in real estate with almost no money.

Another problem with real estate investing has always been that it’s not quite as passive as many people think when they get started. Owning a few single-family rentals is one thing. Build any kind of a portfolio though and it can become a full-time job.

That’s why I’ve supplemented the more active real estate investing strategies with ones that require less work like crowdfunding and partnerships.

A new passive income strategy for investing in real estate is through property-backed loans on PeerStreet. New laws around crowdfunding have opened the door for websites like PeerStreet which allow investors access to real estate projects. Properties are professionally-managed so you don’t have to worry about a 3am call to fix a leaky faucet and management fees are lower than investing in REITs.

real estate crowdfunding investment review

PeerStreet offers investment in real estate debt on commercial property. Since the debt is back by the property, it’s much safer than equity investment but still targets returns between 8% and 12% on an annual basis. I use PeerStreet to balance out the risk in my equity investments on other platforms.

Check out available investments on PeerStreet

passive income investing explained

What are Peer Loans and Lending Club Investing?

P2P and Lending Club investing is really nothing new. Investors have been putting their money in bank loans for ages. Banks are in the business of making loans, not holding them on the books. They sell their loans to investors that need stable returns.

I can almost guarantee you already own loan investments through any pension fund or insurance policy because these companies are the biggest buyers of loans.

The only difference is that investing in bank loans was only open to wealthy individuals and large institutional investors.

Lending Club and other peer lending sites opens up the investment to everyone. Borrowers for personal loans fill out an application just like any traditional bank loan. Their credit report is checked and the application is verified by the website.

Lending Club then separates the applications into seven risk categories and 35 sub-categories to assign an interest rate on the loan. Investors can browse through loans and decide in which they want to invest.

lending club returns for investors
Lending Club Returns by Loan Grade

One of the misconceptions about Lending Club investing is that you are required to invest in all loans. You choose the loans in which you want to invest and can put as little as $25 on any particular loan.

Lending Club offers a great screening tool to help you pick loans on different factors like a borrower’s debt-to-income ratio, home ownership, delinquencies, credit history and more factors from their credit report than you will ever need. It really helps to customize a portfolio of loans on your own risk tolerance and need for return.

In fact, using this screening tool is the way I’ve been able to get higher returns that the average investor on the platform. Lending Club shows the average investor earns around 7.5% on a mix of loans from all those available.

What is hidden in this return is the default rate, the percentage of loans that are not paid off in full by borrowers. The average interest rate charged on loans across Lending Club is closer to 13% but the average default rate of 5.5% means investors only see that 7.5% return.

By using the screener to only pick the best loans, those with the lowest likelihood of default, I’ve been able to boost my annual returns to 10% and keep them there for years.

I’ll reveal the loan filters I use and talk more about this but you can also watch this video where I walk you through the process.

I invest relatively conservatively with almost all my money in the safest three categories of borrowers. I still get an average rate of 11.6% on borrowers with FICO scores above 700 and with below average debt.

my 2018 p2p lending strategy
My P2P Investing Strategy on Lending Club for 2018

Borrowers make monthly payments for up to five years and the platform automatically deposits your portion of the payment into your account each month. You receive interest and principal in each loan payment.

If a borrower stops making payments, Lending Club sends the loan to a collection agency. Typical collection amounts are pretty low but defaults tend to be in the single-digit percentages anyway, especially in the safer categories.

The average borrower on Lending Club has a credit score of 699 and makes $74,414 annually, putting them in the top 10% of U.S. households. That’s helped the platform avoid some of the higher default rates on other peer lending sites.

Lending Club Returns and Peer Lending Investing

Lending Club has helped fund more than $18 billion in loans since 2006 with more than four billion of that just in the last year. I’ve been investing in Lending Club loans for years and love the asset class for stable returns and diversification.

Your return on Lending Club loans comes in monthly which makes it a great source of cash for people living on a fixed-income. Returns on peer lending are going to depend on the loans in which you invest but the percentages across each category are surprisingly stable.

We’ll go into different Lending Club returns you might expect on different strategies but the graphic above serves as a good guide. Returns on the safest categories of loans range from 5% to 7% while higher-risk loans can return as high as 10% annually.

lending club investor returns
Lending Club Investor Returns – Investor Interview

Remember that the average Lending Club returns within each category are for only loans in that category. By combining loans from multiple categories, you can increase your return while smoothing out the risks in the higher-risk loans.

How Do You Invest on Lending Club?

Opening an account on Lending Club takes less than five minutes though it will take a few days to link your bank account and fund your p2p account. You’ll need contact information and your social security for tax purposes but that’s pretty much it.

I recommend opening a retirement account like an IRA, Roth IRA or SEP IRA. Otherwise, you’ll pay taxes every year on the interest you collect. You can still book solid returns after income taxes but why not take advantage of these special retirement accounts and not pay taxes until you retire?

Use your retirement accounts for high-yield investments like peer-to-peer lending and a regular taxable account for long-term investments where capital gains are the biggest share of returns.

Before investing on Lending Club, it helps to understand a little about picking loans. I’ll detail the criteria I use as well as three Lending Club strategies below. Basically though, you are picking loans by selecting criteria about those loans or the borrowers.

By being picky with your loan criteria, you can fine-tune your investments for higher return and higher risk or for lower risk and return.

When you decide to invest, click on Invest in the menu at the top of the page to see available loans. You can invest as little as $25 in any loans that meet your criteria but I like to keep around 200 loans in my portfolio.

That means dividing your total account by 200 for about how much to invest in each loan. That keeps you from having to search for hundreds of loans all the time but makes sure your money is diversified.

Lending Club Investing Strategies for Any Investor

Your Lending Club investing strategy is going to depend on your risk tolerance and need for return on your overall portfolio. Most investors will probably be comfortable putting up to 20% of their portfolio in peer loans as part of their bond asset class investment.

If you’re not sure about your risk tolerance or how to start investing, check out this post on creating a personal investment plan.

The idea is to look at Lending Club loans as a part of your entire wealth, not on a standalone basis. You’re not just investing in Lending Club loans but have a whole portfolio of stocks, bonds, real estate and other assets.

If you were looking at some of the higher-risk peer loan categories in isolation, they may seem way too risky. Look at these same loan categories in the context of a portfolio that holds many different asset classes though and they fit as diversification with a higher return.

Choosing loans in which to invest is extremely easy with Lending Club’s screening tool. You choose your loan criteria and the screen populates with available loans. This helps to create an investment strategy customized to your own needs.

lending club investing strategies
Lending Club Investing Strategies – How to Pick Loans

Super-safe Lending Club Investment Strategy

While some investors prefer to invest in the riskier loan categories for a higher return, there are a lot of investors that use Lending Club as a part of their relatively-safe bond investing portion of a portfolio. Loans are debt obligations on a borrower’s credit so must be paid off unless the person wants to destroy their credit score.

Borrowers in the top two or three rating categories have excellent credit scores, well above 700 FICO and make more than $80,000 annually. Combined with a few of the criteria below, these aren’t the kind of people that are going to ruin their credit on a small $5,000 loan.

For solid returns at lower default rates, I use the factors below for a safe Lending Club investment strategy.

  • Loans from A, B or C
  • Home Ownership
  • Income Verified
  • No accounts delinquent
  • No charge-offs in the last 12-months
  • Debt-to-Income of less than 30%

The return on loans with these factors has generally been around 6.5% annually, well above the return on investment-grade corporate bonds and even above corporate high-yield debt.

A Lending Club Investing Strategy for Higher Returns

Investing in peer loans can still be fairly safe, even on investing strategies for higher returns. The most important idea is that you diversify across many loans and use a few criteria to weed out the lower quality loans.

I wouldn’t recommend chasing very high returns for most investors but if you can stomach higher defaults then you can make a great return on higher-risk loans. Understand that while default rates are higher in the risky loan categories, rates are higher and your return will even out on a portfolio of 100+ loans.

Consider some of these factors for a high return Lending Club investment strategy:

  • Within loan grades D/E, all 60-month loans and no delinquencies
  • Within loan grades F/G, only 36-month loans, no delinquencies, DTI < 30% and no credit inquiries in last six months

Limiting the loans you buy within the higher-risk categories will help lower defaults but you’re still going to see some loans go into non-payment. It’s just a reality of peer loan investing. You should still be able to book an annual return of around 12% on your portfolio of loans.

Is Lending Club Passive Income?

One of the best features on Lending Club is the automatic investing tool, something like robo-investing for peer loans. You customize the screener for the types of loans in which you want to invest and Lending Club will automatically invest the money in your account each month.

You receive interest and principal payments each month, money that isn’t going to be earning a return until you reinvest it. That makes cash sitting in your account one of the biggest drawbacks to p2p investing.

Lending Club passive income
Lending Club Passive Income with Auto-Investing

Lending Club doesn’t charge a commission when you invest so you won’t see fees eat away at your return like in stock investing. A 1% payment fee is deducted from each loan payment that comes in. This means you don’t pay a fee on defaulted loans.

Even if you want to invest in individual loans on your own, I would recommend letting the automatic investing tool pick some loans each month. One of the Lending Club invest tips below is to stay fully invested because money in your account isn’t generating profits otherwise.

You may have to tweak your investing criteria a little to stay fully invested, depending on loan availability. Still, the automatic tool on Lending Club makes it about as close to passive income as you’ll see in most asset classes.

Everyone needs a passive income investing strategy to complement their full-time earnings and someday to retire on the future you deserve. From dividends to real estate and peer-to-peer investing on Lending Club, these three passive income investing strategies will boost your monthly income without the work. For more passive income ideas, be sure to click through and join the Let’s Talk Money community on YouTube!

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Comments

  1. This is some great piece of useful info. Thanks for taking the time to do this! for all of us P2P rookies out there. Lending Club is a great platform, also diversfying your investment among platforms can disminish the risk. I think lending club is a good choice also rebuildingsociety, if you are in the UK. Loved the article! thanks

    • This article was posted in March 2018, but the previous comment by Irene is from August 2016?
      Anyway, great article. I was getting really good returns investing in LC a couple of years ago, averaging about a 9% return. It’s dropped off dramatically in the past year to about a 5.25% return. I know credit card companies have seen their default rates rise quite dramatically so I guess its the same with LC. I continue to keep some of my portfolio with LC.

      • I’ve updated the post a few times to keep it relevant, that’s why publication date differs from some of the comments. Yeah, I’ve seen default rates creep up on Lending Club as well. Sucks but it’s something we’re seeing on all debt investments. I’m waiting for a full-blown recession and stock market selloff to see how it holds up. Even a small positive return against double-digit drop in stocks would do it for me.

      • RJSLARX, I am considering investing in Lending Club. I am curious, were you consistently reinvesting the monthly payments of principle and interest? Do you think that would have offset the diminished return?

  2. Investors need to understand that economic conditions change, which changes the relative attractiveness of certain investments like peer to peer loans. In addition, underwriting standards at Lending Club have changed. This will impact the default rate going forward and is not reflected in the historical data. Overall your strategy is sound and the data support most of your methods. Still, there is room for improvement, particularly when the economic environment changes for the worse.

    • It’s true you can’t predict future returns on historical data but p2p loans should outperform stocks in a market correction. They are debt obligations like bonds so generally safer than equity. Underwriting standards at Lending Club have changed but for the better, with new changes to the algorithm that prices loans.

  3. Good information! I’ve made changes on Lending Club and Prosper platforms. I’ve tried several robots that were supposed to manage the portfolio, but they only put me into high risk loans. These criteria you’ve laid out make sense to me, and I’m certain that I’ll see better results. Thank you!

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