Peer to Peer Lending Review

One of the side effects of the atrocious market we have endured in recent months is incredibly low interest rates on deposit accounts. Bank savings accounts are earning less than 1% yield, and even traditionally higher online savings accounts at the best online banks, such as ING Direct, are only offering 2.75% APY (at the time of this writing).  What’s a conservative-leaning investor to do?

If you are up for taking on slightly more risk for the chance of a lot more reward, the peer-to-peer lending industry might be the place for you.  I was admittedly skeptical when peer-to-peer lenders first came on the scene, but the more I’ve learned about the industry, the more I appreciate its ability to cut out the middle man (banks).

What is Peer to Peer Lending?

Peer-to-Peer lending involves investors pooling their money to fund loans for borrowers in the private market.  Interest rates vary according to the credit risk for a particular borrower, but it isn’t uncommon for investors to earn over 6% or 7% on loans for those with good credit, and much more on riskier borrowing prospects.

One of the aspects of peer-to-peer lending that appeals most to me is the fact that banks are cut out of the lending cycle and power is pushed down to the average citizen.  Perhaps it appeals to my entrepreneurial spirit.  I might not be able to fully fund your $10,000 debt consolidation loan, but I can pitch in $100 along with dozens of other investors.  This helps spread the risk around a bit so that no single investor is heavily leveraged in any one loan deal.  It also provides borrowers greater opportunity for receiving a loan in this tightening credit market.

Borrowers are asked to fill out a profile including a compelling description indicating the reason they are in need of a loan.  This has a way of personalizing the request.  Perusing the current loan listings at Lending Club I see a variety of loan requests from debt consolidation, to a used car purchase, to a request for start-up capital to fund a new business idea.  Knowing that you are investing in someone’s dream is exciting!

Peer-to-peer lenders, such as Lending Club, also grade borrowers based on their creditworthiness including such factors as debt-to-income ratio, credit scores, etc.  Of course, it isn’t foolproof, and there are risks of defaults and late payments, particularly when peer to peer lending to borrowers with bad credit.  However, several well-placed investments in loans could make for a portfolio producing a much higher yield than other types of cash investments.

How Much to Invest in Peer-to-Peer Lending?

I personally treat this type of investing much the same way I treat single-stock investing; I don’t put more than 10% of my overall portfolio in either investment.  The bulk of my investing is for retirement inside growth stock mutual funds.  Outside of retirement funds I stash emergency fund cash away in an online savings account, and with any remaining cash I may dabble in things like peer-to-peer lending or investing in single stocks I feel good about over the long-term, and have a history of producing great dividends.

So like anything else I recommend here, don’t dump all your eggs in one basket.  Start small until you get the hang of social lending.

Interested in finding out more about social lending?  Join me over at Lending Club!

Comments

  1. I’m sorry but there is a reason that banks and loan companies do this sort of thing — handling the mess that gets left behind when someone doesn’t pay their bills. They employ professional account managers, debt collectors, and teams of lawyers to handle problem clients. Who handles problems like this in a peer-to-peer (P2P) loan situation? In many markets, the middle man provides a much-needed abstraction of what really goes on. I mean, do you really want to pop on down to the slaughterhouse to buy a side of beef and portion it yourself? Many don’t, hence the convenience of your local butcher’s block. Besides, when you get right down to it, a bank is not a middle man. They are the lender and the collector and get their money straight from a federal reserve bank which regular folk cannot deal with anyway. Unless you are dealing with a mortgage broker or a corner loan store, then you have already cut out the middle man.

    Also, wouldn’t the repayment duration have to be at 5 years or less in order to even make it worth the investment? And what happens when someone prematurely pays off the loan? Do you screwed out of the interest?

  2. @DavidK, depending on the terms of the loan, a prematured payoff would have you “screwed out of the interest”, but you would get your money back and can then invest it elsewhere. Even most corporate bonds have an option to pay off early, so this isn’t new for fixed income investors.

    The Lending Club serves as the admin for investors and borrowers, so in essence this does reduce the presence of a middle man. They also take care of debt collections and all that legal jazz.

    I for one am glad to see the Lending Club’s presence. If I had thousands I needed to invest, I would look at the Lending Club and find worthy causes.

  3. ZimpleMoney.com is an option for Frugal Dad readers. ZimpleMoney is a friend and family lending site designed for making loans to people you know AND already trust! All you need to do is login, become a member, and start a loan to or from someone you know. Probably best if you have talked about it first, ZimpleMoney is not a marketplace where people make bids on loans to people they do not know. Rather it is a site where friends and family can help the ones they love and trust most. I hope your readers will check it out. Zimpley, Steve Rabago ZEO, ZimpleMoney

  4. I agree with DavidK. This seems like a messy, not to mention complicated, under-diversified, and highly risky way to make money. I’d rather have the peace of mind from having cash in FDIC insured accounts, even if I could be earning few percent elsewhere. Also, if you make too much from this basically you are essentially at the same level as payday loan shops and loan sharks.

  5. Don’t you think that people are starting to default more on these kind of loans? I mean, yield is always the translation of the price of risk.

    If you can get 10% in this economic situation, I think you have to think twice before “investing” in someone else’s project ;-)

  6. Do you guys really think that the banks exist for other reasons other than making tons of money and taking advantage of regular people? If you don’t think that banks are not just greedy middle men that pay you 2-4% while charging people 18-30% on loans and credit cards, then you must think we are not in a financial crisis because of them.

    I love the idea of Lending Club! take the lending and borrowing back to the people, the way it was done before.

  7. Sorry IndependentThinker, apparently you don’t like to accept the fact that almost all banks started the way the Lending Club has. Lots of people throwing their money into the pot and getting interest back as profit. It’s not a new invention just because it involves the internet.

    As a side point on these P2P lending agencies, how do they pay the personnel that run the agencies? If they pay the investors 6-7%, then they must be charging the borrowers at least 9-10% in order to cover expenses if they do have people who manage the accounts and collect on bad borrowers. Also, where does the money go if the company goes under?

  8. @DavidK:

    If you did some research before rattling off, you would have found out that these P2P lending sites DO NOT make money on the spread like banks do. They charge a small fee to lenders (1%) when they get money back. All the interest that comes back from the borrower goes to you as a lender. Now, is that not a win win?

  9. I went to lending club for a loan to grow my business, which I started six months prior. It all starts out easy enough but the more you progress through the process, the more it looks, smells, and feels like a bank. My loan request went public to the investment side of the community and was 90% funded when I was contacted by Lending Club’s underwriting arm to inform me that I do not qualify for the loan because I have not been in business long enough.

    If I wanted to be rejected for a loan I would have went to a bank. Not being in business long enough to justify the loan is precisely why I didn’t go to a bank. It’s the underwriters who call the shots on who get’s what loan, just like a bank and the process — the paperwork you have to submit — is also just like a bank. Also, their fees may not be hidden but they are steep and they do not tell you about them until you apply for the loan and they run your credit. Should I have qualified for the loan, they would have taken about $1,200 off the top as a fee. (I suspect that the fee would about cancel out the 1 point or so in interest savings from a traditional bank.)

    Lending club is not the Shangri-La of individual small investors lending to those with unique circumstances. My credit is great but because I’m a start-up business I’m right back to square-one.

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