With interest rates painfully low, it’s hard to earn much from buying bonds or CDs. However, there is a relatively new way to earn more by participating in what’s known as peer-to-peer (P2P) lending through companies such as Lending Club, Prosper and others.
P2P lending is sometimes referred to as marketplace lending. According to Peter Renton, founder of P2P news source Lend Academy, investor returns have averaged about 7 percent annually over the past several years.
Here’s how buying these loan notes works and what you need to know. This piece will concentrate on Lending Club, as it is the largest, with nearly $16 billion in loans originated, and I have over three years’ experience in dabbling with loans from this firm.
Borrowers who would traditionally turn to a bank instead take out a personal loan through a P2P lending company for up to $35,000, typically paying the loan back over three to five years. The P2P lending company cuts out the bank and goes directly to investors to fund the loan. Most people (though it’s not allowed in some states) can sign up to be lenders and buy fractional portions of these loans for as little as $25. Thus, for example, an investor with $2,500 could diversify by buying shares in 100 loans.
According to Lending Club, P2P investors have earned average net returns (after fees and charge-offs for defaults) ranging from 5.24 percent for their highest-grade A rated loans to about 9 percent for their lowest-grade E, F and G rated loans. Not too shabby.
Borrowers who default on their loans will cause charge-offs for the investor. P2P lenders service the loans and deposit funds collected (less a fee) into investors’ accounts.
Though it’s tempting to jump right in to earn three to four times the rates of high-quality bonds and CDs, it’s critical to get educated before participating, and Lend Academy is a good place to start. You also want to keep the following points in mind.
- Understand that you are buying unsecured loans. Borrowers were paying an average annual rate of 12.6 percent over the past quarter, according to Lending Club. I asked Lending Club CEO Renaud Laplanche why any borrower with good credit would pay higher rates starting at 7.71 percent when much lower rates, secured by a home, are available. Laplanche responded that many borrowers are younger and don’t own a home.
- Unlike a bond, these notes aren’t as easy to sell if you should need your money back suddenly. Laplanche said one can sell the loans through Lending Club’s folio investing trading platform. He noted that the loans are typically sold in about five business days for an average price equal to the outstanding balance. So, for example, if you bought a piece of a loan for $25 and the borrower had paid down $10 in principal, your portion of the loan would have an outstanding balance of $15.
- The loans you are buying are only as good as the P2P lending company. The borrower could make every payment and the investor could still be out of luck if something bad happened to the P2P lending company. Laplanche explained that economically the transaction is peer to peer but, on a legal basis, you are investing in notes issued by Lending Club. One P2P lending company in Europe, TrustBuddy, filed for bankruptcy last year.
I put my toe in the water with $2,500 in Lending Club in September 2012. Within months, Lending Cub was showing that I was earning an amazing 11.08 percent annualized rate. Was I lucky or skillful in picking loans to buy? It turns out, neither. I investigated and wrote a critical review of Lending Club, noting it was overstating returns by not marking down delinquent notes. Lending Club responded by changing the site to show returns that take such delinquencies into account, and I revised my review. As of Feb. 25, with nearly 42 months of investing, my annualized return has averaged only 4.1 percent. That’s more than I could get with a CD, but nothing to write home about. Laplanche observed that my returns were significantly below average, meaning I either lack skill in picking notes or was unlucky.
If you are looking to earn a bit more with your money, P2P lending may be appropriate for some portion of your savings. Remember, however, that these are illiquid and unsecured loans. If the economy tanks, causing more borrowers to default, or the P2P lender gets into financial trouble, these loans may not be sold so easily. Further, they are not substitutes for safer options such as CDs or government bond funds. I have a tiny portion of my portfolio in Lending Club and consider it part of my “fun” portfolio. Still, I’m impressed enough with Lending Club to continue having some fun.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.