Four Peer-to-Peer Loan Investor Tips

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Screenshot of LendingClubScared off by stocks and real estate but seeking a higher return than a savings account? Consider testing social lending, where individuals loan money to each other. The returns can be quite attractive, but these loans are often quite risky as well.

While they are a bit more established in Europe, nearly a dozen social lending sites (also known as peer-to-peer or P2P loan networks) burst onto the scene in the U.S. over the past two years, aiming to match individual borrowers and lenders. After a period of both wild growth and often abysmal default rates, the S.E.C. cracked down, essentially forcing the companies to register their loans as public securities. This forced every network to unexpectedly pause new lending operations while they await S.E.C. approval to resume originating new loans. Thus, the spotlight that had been shining brightly on this market has dimmed considerably, with only two social lending marketplaces completing the registration process and resuming lending so far: Lending Club and Pertuity Direct.

If you are ready to dip your toe into this market, here’s our advice for getting started:

  1. Start small. Lending Club will let you commit as little as $25 to a loan. Though the high interest rates (averaging over 9%) may sound irresistible right now, take some time to see how the process goes before you dive in with your entire intended investment. As the current banking crisis clearly shows, even the most highly trained and experienced credit analysts can back the wrong borrowers.
  2. Ask questions. Make it a point to ask every borrower a question before committing to their loan, even if they’ve provided thorough detail. How they answer your question can be just as important as what they say. Are they prompt, professional and direct in replying to you? If they don’t communicate with you well now, don’t expect any better treatment if you encounter repayment problems later on.
  3. Diversify. Lending Club shows that 3.03% of its loan portfolio originated over the past year is either late or has been charged-off. (That may not seem like a bad rate on the face, but Lending Club paused new loans until its S.E.C registration was approved in October of 2008, reducing the average age of those loans.) P2P loans carry a material risk of default, which means that you have the very real possibility of losing part or all of your investment. Diversification is the best strategy for minimizing this risk. Spread your investment across various borrowers with different borrowing objectives, geographies, credit ratings and even loan networks.
  4. Make sure rates reflect risk. Don’t be wooed by loans carrying a near-20% interest rate; you’ll be lending to a very high risk borrower who may never pay you back. Instead, focus on the “spread”. Spread is the interest rate above what a comparable loan (such as from a bank) would charge. Given the limited track record of social lending, you should expect to earn several percentage points above comparable rates. Be sure to consider the spread you will receive and not just the absolute interest rate. For example, this borrower wants to pay 8% on a $4,000 loan to purchase a motorcycle. While 8% sure beats earning 3% on a CD, banks are currently charging at least 10% interest on motorcycle loans. The rate on this loan should be priced at several points above what banks charge, making it a poor investment choice.

Remember, P2P loans should be considered to be high-risk, and you could lose your entire investment. As with any investment, be sure to perform your own, thorough due diligence.

This guest post is by Social Lending Network, which offers news and strategies on social lending and P2P loans.

{ 14 comments, please add your thoughts now! }

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14 Responses to “Four Peer-to-Peer Loan Investor Tips”

  1. SJ says:

    I am kind of confused by the last one…
    isn’t the point of p2p loans to meet in between the cd and motorcycle loan rates?

    • Claus @ says:

      I agree with Gary that 8% interest rate is probably to low to get a decent ROI with the risks involved.

      Nevertheless you are right, SJ, the whole idea is that both sides, lender and borrower win by elimnating the bank as the middleman who takes the spread.

      The tips are good, there is definately a learing curve as lender and the services evolve as they mature (they are still pretty young) and naturely the market, the rates and the defaults develop.

      It’s fun and unexpensive to put a toe in the water, so try it if it interests you.

  2. @ SJ – I think that he means do not lend to a high-risk borrower at a low interest rate.


  3. Larry says:

    @SJ Yes, optimally the borrower is paying a lower rate and the lender is earning a higher rate than if a bank or other middle man were involved. However, the base rate should be cost of a bank loan on a motorcycle, not a CD. Nate has it right.

  4. SJ says:

    Okay I am confused, but I reread the last point.
    I guess I would want a “spread” to contemplate for the slightly higher risk that I am taking as a loaner.

    But so we are accepting that the other party is unable to get a loan thru traditional methods? Which is why they are willing to accept the higher rates?

    I think that kind of clears things…

    The other case would be pairing low-risk loanee’s w/ investors, the problem arising that those people would be less likely to pursue p2p or need it?

  5. GaryG says:

    Something to look at is the Loan Grade. In the case of the motorcycle it is A3. There are only 2 sub grades higher than this. So this would be relatively lower risk. If someone has a good credit rating then they would use a P2P lending club to try to get a better interest rate than you could get at a traditional lending institution.

  6. jen says:

    It seems most of the p2p lending is not available in Texas. How about Pertuity Direct? Are other states eventually going to be added? It’s so frustrating not to be able to try this!

  7. Eric says:

    Good stuff…I’m still trying to find some loans to fund my referral bonus with actually. 🙂

  8. dmeanea says:

    Jim, are there any P2P lending services that will manage diversification for you? For instance, let you specify how much money you want to loan on a specific risk rating and desired return, and spread your investment out over several loans?

  9. Chiko says:

    Thanks, I plan to sign up with Lending Club pretty soon and really got a lot from these four tips.

    • Jim says:

      Tomorrow afternoon I have a post that does a broad review of the various peer to peer lending options available, so keep an eye out for that.

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