Peer-to-Peer (P2P) lending is a new investment option that I have begun investing in over the past few months. If you’re looking to diversify your investments outside of just stocks and bonds and you’re looking to get a higher rate of return than your bank is offering you on your savings or CD’s peer-to-peer lending might be right for you.
What is Peer-to-Peer Lending?
P2P lending is a form of lending that basically cuts out the banks as traditional middlemen. P2P lending takes place though two main online platforms: Lending Club and Prosper. Lending Club and Prosper connect borrowers looking for more attractive loan rates than they can get from a bank or credit card to investors looking for higher rates of return than they are receiving in other types of investments. The sites also screen borrowers credit worthiness and determine the interest rate to be paid on their loan accordingly.
Advantages for Borrowers
Let’s face reality for a second and admit that no matter how many finance blogs exist, the majority of Americans don’t have enough cash lying around to pay for a major expenditure should one arise. Getting a personal loan for something like a major home repair or a wedding can be nearly impossible if you don’t have near perfect credit. Even if you do, the rates they give you on such a loan are pretty astronomical. With peer-to-peer lending borrowers are given the opportunity to obtain financing for themselves at a much more attractive rate than a personal loan from a bank, and definitely better than putting the expense on a credit card.
With peer-to-peer lending, borrowers are also given the opportunity to “sell” themselves to the investors that will be funding their loan. They can explain a bit about their financial history, exactly what the loan is for and even answer questions directly from individuals looking to invest.
Advantages for Investors
For investors looking for an alternative to the stock market but still want to earn a high rate of return on their money (both sites claim the average investor earns approx 10%) peer-to-peer lending is the perfect alternative. When you deposit into your Lending Club or Prosper account you get total control over what loans you invest in and how much you invest in each loan (both sites do offer a more automated, generic approach for the lazy among us). You determine exactly how much risk you’re taking with your money and know exactly what interest rate you’ll be receiving on your investment in each loan. In many ways its win-win.
Disadvantages of P2P Lending
The disadvantages of peer-to-peer lending for investors lies in the fact that these are unsecured loans and there is always the risk of the borrower defaulting on the loan resulting in a loss of all or part of your investment. Both Lending Club and Prosper screen borrowers carefully and both sites claim to have very low default rates. But the risk is impossible to completely avoid. As an investor you must realize, that as with any investment your rate of return is proportional to the inherent risk of the investment. Any P2P investments you make should only make up a portion of your overall investment portfolio that is in line with your individual risk tolerance.
Also, P2P lending isn’t available in every state. Currently residents of Indiana, Idaho, Iowa, Maine, Mississippi, Nebraska, North Dakota, Ohio, Tennessee, Texas and Vermont are not permitted to invest, or borrow via P2P lending.
My Experience with Peer-to-Peer Lending
I opened up an account with Lending Club back in July. I had read a lot about P2P lending on other personal finance sites and wanted to give it a shot myself to see if it was all hype or not. I initially deposited $500 into my Lending Club account and don’t plan on adding any more until I see how this all works out over at least a full year.
With my $500 I invested in 18 different loans. I stuck to investing the minimum of $25 in each loan (with the exception of 2, don’t ask me why) in order to spread out my risk and minimize my chances of a big loss. As borrowers make payments I plan on re-investing that money into more and more loans. As of writing I am currently invested in 19 different loans on Lending Club.
So far, so good. All of the borrowers I have invested in have kept their loans current to date. I’m not naive enough to think that I’m going to be batting 1.000 for the life of each of these loans. But as long as I continue to invest only small amounts in each loan I hope to minimize my overall risk should any particular borrower flake out and default on their loan.
As long as I continue to minimize that risk I think P2P lending will be a great way for me to build a reliable stream of truly passive income while diversifying my overall investment portfolio.
How I Choose Loans To Invest In
To the side you can see the exact criteria I use as an initial screen when looking for loans to invest in on Lending Club.
I look for a maximum debt-to-income ratio of 25% or less to ensure that the borrower isn’t drowning in debt already. The lower the amount of debt they carry the easier it will be to pay off the loan they’re about to take out.
I don’t initially screen for home ownership, although I do consider owning a home or being in good standing on a mortgage a plus a little further down the line. It’s just one more thing to signal that this person is a responsible borrower and won’t be flaking out on their loan.
Obviously I don’t want to be investing in anyone who has had any credit delinquencies over the past 24 months. Nothing against those people, as I know s**t happens, but it’s just not a risk I’m willing to take with my money.
Verified income is another big thing for me. The peace of mind that Lending Club was able to verify the borrowers employment and income is definitely reassuring to me as an investor. Note to borrowers: the more solid information you provide, the better your chances of getting money!
I also don’t like to see a lot of recent credit inquiries. These come from applying for credit cards and other loans. Having too many of them in such a short period of time raises some red flags in my eyes.
Minimum Length of employment is also very important in my screening process. After all, how is someone without a job supposed to pay me back?! I go with 2 years of employment as a starter, just because I like to see that they’re a bit stable in their current job before I invest my money in them.
Finally, because I’m investing such a small amount of money right now and want to minimize my risk I stick to only “A” and “B” rated loans. These are the people with the best credit scores and most solid financial backgrounds. While I obviously give up a lot of earning potential by avoiding riskier loans, my goal right now is to keep my risk as low as possible while I gain more experience investing and work out the finer details in my screening process.
I also tend to stick to certain types of loans. I absolutely will not invest in people looking to start a business due to the high rate of failure that is the nature of small businesses. People looking to finance a wedding or engagement ring also aren’t on the top of my list of borrowers to invest in, for me to invest in this type of loan I need to see a very solid financial history.
The same goes for debt consolidation loans. I can’t totally ignore these loans as they are the most prevalent type of loans, but before investing in these I really try to dig down and see what kind of debt they’re consolidating and how much debt they have. With debt consolidation loans I also like to see that the borrower is answering questions from the investors. I like to get as much info as possible before investing in these loans.
Home improvement loans are my favorite types of loans to invest in for a number of reasons. The first being that it shows some sort of responsibility. The home owner is obviously planning to stick around for a while, and if the improvement is for something that will add value to the home it looks even better.
When you boil it all down, my P2P investment strategy is to be as snobby as possible when picking loans to invest in. Even with an inherently risky investment, I want to minimize that risk for myself as much as possible. It’s the same reason I’d rather invest in IBM stock over an unknown biotech stock whose whole future depends on the government deeming their product safe for humans.
Performance of my Peer-to-Peer Lending Portfolio
So far I’m earning a solid 9.39% return on my initial $500 investment in Lending Club. Considering I’ve only been investing in A and B rated loans I’m very happy with the returns I’m seeing so far. If I can make it a full year making these kind of returns without seeing any defaults in my loans I plan on investing more money into Lending Club and making peer-to-peer lending a little larger part of my overall investing strategy. If things do turn sour, I always have the option of selling my loans and exiting the P2P game all together. I honestly don’t see that happening though. So I hope to continue to build my peer-to-peer lending portfolio on Lending Club and eventually have it become a significant stream of passive income at some point down the road.
I will start adding my Lending Club performance to my monthly portfolio updates so you can follow along with my progress. I’d also be happy to answer any questions or concerns any of you may have if you’re considering investing or borrowing with Lending Club or Prosper. Feel free to contact me through my contact page, in the comments to this post or on Twitter.
Thanks for reading! If you enjoyed this post, and want to stay in the loop with all my future posts. Be sure to subscribe to the RSS feed (if you haven’t done so already)!