With CDs and other fixed income products paying laughable yields, investors are searching for places to park their money and earn a decent interest rate. In a previous article, I wrote about 8 ways to earn income when interest rates suck. One of the options that I mentioned, peer-to-peer lending, has started to catch momentum as accredited investors are finally injecting their own cash. As a solid alternative to other, more traditional income investments, P2P lending is a great addition to just about any portfolio.
What Is Peer-to-Peer Lending?
Peer-to-peer or person-to-person lending, is exactly what it sounds like. There are two parties involved in which one lends money to the other in exchange for interest payments. You can act as either the lender or borrower, collecting or paying an annual interest rate.
As a lender, your transactions can take place in a standard investment account, retirement account and even a 401(k). When borrowing funds, you can only do so in a standard account.
How Peer-to-Peer Lending Works
There are two primary lending companies today – Lending Club and Prosper. Other microlending sites exists, but because of certain risks I will discuss later, I would recommend staying away from these. Both Lending Club and Prosper perform the same function and basic mechanics. From what I’ve researched, both companies also do a great job at collecting the payments and distributing the funds to the lender. There are however, differences in terms of fees, loan duration, minimum credit, and other factors that are listed in the chart below:
Aside from the clerical differences, people have reported slightly different returns and default rates with both companies. Of course, your return will depend on what level of risk you’re comfortable with. The higher quality loans will pay lower interest, while the riskiest borrows will have to pay a very high rate. The lower the loan is rated, the greater the chance of default, but some of the A and AA rated loans have the potential to be sent to collections and eventually written off.
If you choose to lend to borrowers with the three highest credit scores, net of defaults, you can expect to receive 5.80, 8.37 and 9.40%. Those are very high returns considering you are lending to the highest quality candidates. Prosper’s returns are very similar for their three highest ratings at 5.24, 6.65 and 9.04%. The rate of return only grows as you take more risks and lend to individuals with a higher chance of default.
Lending Club claims that 93% of lenders produce a return of 6 – 18%, while 6% earn 3 – 6%. Even if you are unfortunate enough to be in the bottom 6%, your return would be multiple times higher than what you can expect from a 5 year CD right now.
Prosper’s success rate is just as impressive as they state that since 2009, every Prosper investor with 100 or more notes, has experienced positive returns. If you invested in the stock market in 2009, it’s doubtful that you could claim the same success rate. They go on to say that you can expect 10.69% Returns With Prosper.com.
If you’ve ever lent money to a friend or family member, you know that repayment is always a risk. These types of loans are no different but at least you get to choose which credit rating you want to lend to. Each company accepts only 10% of the applicants who are looking to borrow money. Concentrating on the highest quality borrowers, they filter out many potential defaults.
On top of the applicant filter, each note is in increments of $25 and a borrower’s loan will be filled by many lenders. This distributes the risk, so you only lose $25 if one of your loans goes to collections.
Each company reports the average default that you can likely expect from each group:
A second risk that I weight more heavily is the probability that the lending company, whether it be Lending Club or Prosper, will cease to exist. As they disclose on their risk pages, your account is neither FDIC nor SIPC insured. In the event that they take massive losses and cannot operate any longer, the company can close its doors and your loans will be worthless. A few years ago, if you had an account with Wachovia, Washington Mutual or any other bank that failed, your funds were secured and serviced by another financial institution.
Will this ever happen? This kind is lending is fairly new so nothing like this has occurred yet. In 2008 though, Prosper did shutdown temporarily to restructure its business after violating certain SEC guidelines. Both companies are now registered with the SEC and all business activities must be filed and disclosed.
As of August 1st, I deposited $5000 with Lending Club. The amount of loans they distribute gave me more confidence when deciding between them and Prosper. I’ve invested 30% in B quality loans (8.37% net annualized return), 40% in C quality (9.40%) and the final 30% in F quality (13.25%). I will periodically disclose my returns and discuss any updates along the way.
Not only are the potential returns great, but you are helping somebody that’s in need of funds for debt consolidation, college or even to pay for a wedding. You could also be helping a small business step up to the next level or buy some crucial equipment. With banks taking fewer risks these days, it’s nice to be able to lend and help others out.
As you read earlier, I lean more towards the Lending Club as a choice over Prosper for Peer-to-Peer Lending. In the pursuit of full disclosure, below are affiliate links for Lending Club:
[The above are affiliate links]
Readers: What do you think about peer-to-peer lending? Do you think the risks are worth the returns?
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