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 and institutional 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:
Expected Returns
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.
Risks
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.
My Investment
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.
Peer to Peer Lending Widely Recognized
Its not just me that’s getting into this, a number of other bloggers have also made forays into the Peer to Peer lending world. Joseph over at peerfinance101 has an excellent overview article on peer to peer financing. Thousandaire.com also has a great calculator for lendingclub.com, if you’re interested in doing a comprehensive analysis of your portfolio.
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. While there still isn’t a lot of data, With banks taking fewer risks these days, it’s nice to be able to lend and help others out.
Readers: What do you think about peer-to-peer lending? Do you think the risks are worth the returns?
I have considered doing things like this, but I’ve heard a few people complain of the borrowers not paying it back. That’s pretty scary to me!
Scary and exciting right?
It’s practically a certainty that some loans will default. At only $25 per loan though, your risk is limited. The returns that each company reports include loan defaults.
I’ve looked into this before but didn’t have any luck signing up and I got rejected. They really do a good job of checking people’s background before signing them up.
Where you rejected as a borrower Aaron? According to their site, they reject 90% of applicants. I’m actually surprised they have as many lower rated loans default when their standards are so high. Maybe people don’t take these loans as seriously as a mortgage or credit card.
Good article. The only thing I take issue with is your assumption that if either company closes its doors “your loans will be worthless”. While I think it is highly unlikely either company will cease to exist, even if that were to happen, there are backup loan servicers in place that will take over the loans so money should flow to the investors still. Of course, there are no guarantees but I think investors are well rewarded for the risks they are taking. Best of luck with your investment.
This industry is just now emerging so it’s hard to say what would happen if one of these companies stops servicing its loans. You’re right though, another company would most likely step in as was the case with Bear Stearns. During its existence, SIPC insurance has NEVER been used even though many investment firms have failed. I’m going to assume the worst until this industry solidifies itself. Perhaps an organization of members, similar to SIPC, is needed to give investors a little more confidence.
Totally agree that a membership organization is needed. Although with really only two major companies right now it hardly seems worth it. But I think in the long run it will happen.
Good point. It seems like these companies have great potential to make money so I’m sure we’ll see many competitors. It’s a matter of time before some of the mega-banks get involved.
I was so interested in peer-to-peer lending until I read that it wasn’t currently permitted in certain states- including mine. I’m going to keep checking back and hoping that things change. I would really like to get involved! I am interested to hear your updates.
I would be very frustrated to find out that it wasn’t permitted in my state. I believe that people should always be given the opportunity to make their own decisions, good or bad. I’m sure it will be allowed in all states as confidence grows and a proven track record is established.
This is interesting post and very informative, i have really enjoyed reading your posts and thank you for sharing this with us.
I really enjoy when people benefit from my posts.
I’ve thought about doing this to diversify my income a little more, but I don’t like the idea of tying up too much of my networth in P2P lending at this point. Maybe some point in the future. If I am going to tie up a lot of my liquid assets, I would much rather it be in something like real estate.
Dollar for dollar, I think real estate is the best investment today. Low rates combined with low prices will equal in a win when we see a recovery.
Tying up your money for 1 – 5 years is one of the drawbacks. You can however sell your loans on a secondary market in the same way that you can sell brokered CDs and bonds. You will take a hit on your principal though.
I never got into P2P mostly because I’m just more comfortable with index funds and things like that in the stock market. It’s not that I necessarily think P2P is significantly riskier than that (spreading it around $25 at a time sure does spread the risk), but the returns just don’t seem incredibly high if you are investing over the long term. A 3-5 year period, of course, is more short- to mid-term than long term, but it just doesn’t scream to me to invest.
Plus, I’m not sure at all, but it sounds like the interest you earn would be taxed at ordinary income rate, as opposed to dividends and capital gains being taxed at favorable rates (at least for now), so if that’s true (I’m no tax expert and haven’t spent a lot of time looking into it) it eats into the returns.
I’d be curious to know if anyone looked into the tax issue…
Your correct Nick, the interest you receive is taxed as ordinary income in a standard account. They do offer IRAs as well, but that’s a whole different topic.
I found this great link when researching the tax impact: Guide to filling out your LendingClub / Prosper tax forms
I have the majority of my money invested in the stock market currently where I write covered calls on many of my stock holdings. I like P2P lending because it adds another layer of diversification to my portfolio.
Always have a collateral to be safe.Even friends have a hard time paying when they are out of job.
That’s a good point. It doesn’t matter how much you like somebody or how much they are determined to pay you back – if they don’t have a job and money coming in, they won’t be able to pay you.
I am happy seeing this review about P2P. I have been with LC for more than 3 years and I am very satisfied making 13% return (XIRR).
Yeah they really do have great returns, and do a great job of mitigating the risk.
Lookiing forward to hearing how things go for you. I have been looking into peer-to-peer lending a lot as it’s becoming really popular. I’m about to pull the trigger and open my account to diversify even more from equities.
Good post. We’re planning to direct some of our investment dollars to P2P in 2014. We have two in college, so holding off on anything new until we feel sure of how finances are going this year.
Playing cautious, rather than fast and easy, while that “data” is still being gathered is an excellent idea. Way to go not letting your money sit in the meantime.
I think peer-to-peer lending is the future of lending. It may not take over, but it cuts the large middle man (large banks) out of the middle between lenders and borrowers. It turns savers into lenders and borrows can potentially get a lower interest rate as they can borrow more directly from savers who are willing to give loans at a lower rate than a big bank may loan money at.