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Scared 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 ^[3] 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 ^[3] 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% ^[4] 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 ^[5] 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 ^[6], which offers news and strategies on social lending and P2P loans.