Taking a Peek at Peer-to-Peer Lending

Peer-to-peer lending can earn you a higher rate of return than a savings account or certificate of deposit—as long as you're careful.

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I’m not much of a risk-taker when it comes to investing. I live by the old adage, “Be wary of investments you don’t understand.” That limits a lot of my options.

Plus, I’ve been writing about personal finance for almost seven years now. I’ve learned how the markets work. And for the most part, they seem to work by milking average investors like you and me of our hard-earned money. (Don’t believe me? Read the Pulitzer-prize winning Den of Thieves; it’ll make you never trust a banker or broker again.)

For the past few years, all of my investments have been in two things: municipal bonds and index funds. These are investments I understand. They’re investments with very little “drag” — there aren’t a lot of brokerage fees being skimmed off the top before I get my share. I’ll never earn spectacular returns, but I feel confident that I’m never going to suffer catastrophic losses either.

Lately, though, another investment option has caught my eye: peer-to-peer (P2P) lending.

P2P lending basically works like this: Somebody who needs to borrow money goes to a company like Prosper or Lending Club and applies for credit. Once approved, the borrower is assigned to a risk category, which determines the interest rate of the loan(s) he or she receives. Then, that loan is funded by an individual investor (or group of investors) who acts as the lender.

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This turns out to be a good deal for borrowers because they get a better interest rate than they might through a traditional bank loan or credit card. But it’s also a good deal for lenders because they earn a higher return than they can through a savings account or certificate of deposit. (And, of course, it’s a good deal for the company arranging the loan because it skims money off every transaction.)

P2P lending has been around for six or seven years, but I’ve always been wary of it until now.

Over the past few months, I’ve talked with several other financial writers who have begun to experiment with P2P lending. Like me, they’re cautiously optimistic about the potential returns.

Recently, on a trip to San Francisco, I had a chance to stop by the headquarters of Lending Club, the largest P2P company in the U.S. Earlier this month, they reached one billion dollars of loans funded. I spoke with the company’s CEO and founder, Renaud Laplanche, about why I should put my money into P2P loans.

“We focus on providing good terms to borrowers with good credit rather than chasing borrowers with bad credit,” Laplanche told me. “We decline over 90% of the loan applications we receive. That’s the price we pay to deliver predictable performance to investors.”

Laplanche told me that P2P lending — at least through his company — has less volatility than the stock market. The ups and downs aren’t nearly as nerve-wracking. But the price you pay is a lack of liquidity; you can’t just sell your notes the way you might sell a stock or mutual fund.

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And if I invest some of my money in P2P loans, how will the poor economy affect performance? Laplanche says Lending Club weathered the market crash of 2008-2009 just fine. “The main macroeconomic factor that has an impact on investors is the unemployment rate. More specifically, the rate of job loss.” In other words, if unemployment is increasing, borrower default rates increase and investor returns decrease.

My main concern is putting all of my money into a handful of loans. If one borrower defaults, I’m screwed. Laplanche assured me that isn’t a problem. “It’s quite simple to achieve diversification,” he said. “Our website automates the process.” In fact, he told me that no investor who has ever taken out more than 800 notes (at $25 each) has ever lost money. “If you can’t reach the 800 note threshold, even 400 notes or 200 notes is good diversification,” Laplanche said.

I haven’t moved any of my money from mutual funds to P2P loans yet. But I will. Right now, I’m buying a house. When that process is finished, one of my goals for the new year will be to build a portfolio of P2P loans. Not only do the returns seem promising, but they’re an investment I can understand. And to me, that’s almost as important.

6 comments
PeerLendAdvisor
PeerLendAdvisor

I believe Lending Club, Prosper.com, and P2P Lending in general are the future of banking.

For people looking to get the oversized returns of Peer to Peer Lending and market diversification, they should check out http://www.peerlendingadvisors.com.

PookyWelch
PookyWelch

I think peer-to-peer commerce is awesome.  It's not just about money, cars, or apartments.  It should be about everything and anything. My friend recently launched a service that follows the same peer-to-peer lending concept: www.CameraLends.com, a peer-to-peer local camera gear website. They've launched in SF. I'm excited to see it keep growing!

uk2caguy
uk2caguy

Good article JD. However something to keep in mind if you plan on investing in these p2p notes is that any interest earned is considered regular income not capital gains. So if the notes are not in a tax advantaged account such as an IRA or Roth and depending upon your tax bracket you could end up paying a lot more tax on your gains than from regular stocks or mutual funds etc. That said I am planning on converting my Roth IRA over to Lending Tree since I will never have to incur tax on that money.

yvandemunck
yvandemunck

Slowly but surely the (mainstream) world is turning to the obvious : getting a piece of this action. For the first time in history, because of entrepreneurial ingenuity combined with technology (Web 2.0), it is no longer banks and credit card companies only that have exclusive access to what is called the prime and super prime borrower (FICO score above 660) - an asset class by the way that has delivered consistently high returns over long periods of time. With Lendingclub now effectively doubling its loan volume every year, it is growing rapidly, but still barely scratching the surface. With US consumer debt at around $ 2.4 Trillion, and outstanding credit card debt at around $ 672 Billion, it becomes obvious that a long period of very high growth for this industry is in the offing, all this to the benefit of both borrowers and investors i.e. lenders (Lendingclub just passed the $ 1 Billion mark this month). It is truly one of the great examples of financial disintermediation, and one that a lot of people have yet to discover. Some interesting trivia to finish off : more than 70% of the loans sourced through the Lendingclub platform are used primarily to refinance (at a lower rate) credit card debt, helping a deleveraging trend that continues unabated. What is good for the US consumer is good for the US ? 

FamilyMortgage
FamilyMortgage

Thanks for sharing, JD.  As you're in the market for a home, we thought we would also point out that there are several other companies out their facilitating true p2p loans between relatives and friends.  LendingClub is a great company, but the reality is that the overwhelming majority of their loans these days are funded by institutional investors; if this trend continues, there's very little p2p going on there.  Since launching in 2010, National Family Mortgage has formalized over $60 million in loan volume between relatives, while keeping over $30 million of interest within families.  Our borrowers and lenders both get solid rates, keep money in the family, and protect their relationships; our default rate is less than 1%.  Cheers!

LendAcademy
LendAcademy

Great article JD. As p2p lending matures it is becoming a lower risk investment - I believe it is one the best risk/reward investments available today. The one thing I would like to clarify is that Lending Club has a trading platform where investors can sell their notes. This provides some liquidity in the event the investor needs to get their money back quickly. Let me know when you start investing - be happy to help you get up and running.