Peer2Peer Lending: Is it For You?

As I mentioned on my post on loaning money to the government, interest rates these days are just horrible. I remember with regret the times that I said, jokingly, that soon, banks would charge US for keeping our money.  But I’m no longer joking, because that is exactly what they are doing. While I understand that banks have expenses to pay, I just don’t give up my money that easily! I intend to make money, and so I have gone looking for better ways to invest it than the typical savings account, Money Market or CD.

One of the ways I have found to invest my money for better returns is Peer to Peer lending (or Peer2Peer Lending, as it is commonly known). Have you heard of it? Peer2Peer Lending is an up-and-coming new way of investing that holds great promise.  Peer2Peer Lending is a system by which willing lenders and borrowers meet in a central marketplace to lend and borrow, as it were, to the mutual advantage of each.

Let me emphasize that this is not just a bunch of people getting together throwing money around. Peer2Peer lending is fully regulated by the SEC and by each state (more about that later), so, while like most investments that produce higher returns, there is a chance you will lose your money, and it is not insured by any government agency, Peer2Peer lending has been around a few years. The two major venues for lending have both been through “dark” periods where their processes were cleaned up, and they both emerged better for it.

The two main venues for P2P lending in the United States are Prosper and Lending Club.  While there are many similarities between the two, the details of their operations differ.  I mostly address Lending Club, since I am more conversant with it, though Prosper is also highly regarded. In Lending Club, borrowers apply for a loan in a somewhat grueling process.  Only about 10% of the borrowers pass the first tests. The prospective loans are then rated according to a number of fairly strict criteria, including credit rating, years of employment, length of the loan, previous credit inquiries and several other important variables.  The loans are then rendered as to delete all the major identifying details, and then they are placed on the market for investors to invest in if they so choose.

The investors fund their accounts with transferred money from their banks, and then they begin the process of choosing the loans they wish to invest in. Lenders can also choose to allow Lending Company pick loans for them, simply by specifying the risk profile they wish to fund under. Lenders then can invest any amount from $25.00 at a minimum up to the entire amount currently available in their accounts. Once a loan is fully funded, the borrower receives the cash and begins making payments to Lending Club.  Lending Club takes a 1% fee for itself and divides the payment between principal and interest, distributing this part of the payment among the lenders who have invested in that loan.

It’s always a good idea to watch the lending and borrowing process for a while before funding any loans. Just reading and learning can substantially reduce your risk. For example: you found a great loan with a person who needs $20,000. His risk appears low to you, he only has two previous inquiries on his record, and he writes a wonderful story about how he is coming out of bad times, how he plans to do better in the future and he is going to take this money to pay off his credit cards so he can cut them up and throw them away. Whoa! There are a couple of red flags here already! Two previous recent inquiries means that he has already approached two other lenders, who have either denied him credit or didn’t give him enough of a loan to clear his debt. Also, did you know, (and I’ll admit I didn’t until I read about this) there is a strong negative correlation between 1) the length of the borrower’s description of the reason for the loan and 2) any words in that description that indicate stress or trouble concerning this debt?

Another thing you might not know is that you really should never invest more than $25.00 in any one loan (so this means that the most successful investors own a piece of hundreds of loans). I know that $25.00 does not seem like very much money, but consider: if this borrower defaults on his loan, the most you can possibly lose is $25.00! This is why you need to spread out your risk, because you are not in this investment to lose money! You also need to know that this is not a liquid investment. Once your money has been committed to the borrower, the only way you are going to get it back (and thus be able to withdraw the cash from your account) is for the borrower to repay you.

Interest rates range from a low of some 6% to upward of 22%, depending on the risk profile of each loan.  When was the last time you earned some 10%  or more on your investment?  Heck, when was the last time you even earned 6%?  For me, it’s been a long, long time. When you actually make an investment, before you push the “buy” button, the loan platform will tell you the historical default rate for that particular type of loan and give you an anticipated return rate that also takes into account the expected default rate. This is something you need to take heed of, because from experience I can tell you that you will eventually get a default, even if you invest carefully. Be ready for it when it comes!

Now, about the states. There are some states, including the State of Texas, that deem themselves to be so wise that they do not allow their citizens to invest in this platform directly “for your own good.” In fact, they are so concerned with our welfare that they have made it possible for us to invest ONLY to our detriment. In other words, the only investments we can purchase on the Peer2Peer platform are loans that have already been purchased by someone else and put up for sale on the secondary market. This virtually guarantees that one of two things has happened: 1) the original investor has discovered that the loan is about to default and wants to unload it quickly, or 2) he has decided to jack the rate up for a profit, which will cause any purchaser to get a correspondingly low return.

Thanks, States! We are so happy you are “looking out” for us!

I would not encourage a person to invest in this platform if he or she was even close to being in financial trouble. You should take all your tax-advantaged investment opportunities first, then look to something like Peer2Peer only if you still have money left over and you want to see how you can do with this type of investment. Remember: never invest money you can’t afford to lose. Start slow. Read up!

Image credit: http://www.public-domain-image.com.  Thank you user 401(K) 2012!