What is Peer-to-Peer Lending?

Peer-to-peer lending is a relatively new investment option that connects people who want to invest to people who need loans. It allows lenders to get prime interest rates previously only available to big banks, and it allows borrowers to get better rates by cutting out the middleman. An example will illustrate:

Let's say John is up to his neck in credit card debt. He has $10,000 in debt and has $400/month credit card bills. His interest rate is 25%. John can barely pay his monthly bills so he goes to a peer-to-peer lending site and applies for a $10,000 loan. He gets approved for an %18 interest 5 year loan

Brian is deciding how to invest his savings. He goes on a peer-to-peer lending site and sees John's loan application. He reviews John's credit history information and explanation of his loan application and decides to invest. Brian can invest just a small amount say $100 in John's loan. Other investors also invest and together they give John his $10,000.

John takes the money and pays off his credit card bill. Now he owes a monthly payment of only $250/month and is feeling much more secure in his financial situation. Additionally over the life of the loan he is going to save over $1,000 on interest fees because he reduced his rate from 25% to 18%. Everytime John makes a payment, that payment is split up into little pieces and distributed back to the investors that funded his loan. When the loan is completely paid off the investors will have made back their original investment plus interest.

 

 What are the risks?

Peer-to-peer investing isn't risk free. You can't expect to get an 18% return from an 18% loan. This is becuase you have to factor in the chance that at some point the borrower is unable to make payments and defaults. In that case you don't get the money you invested back.

Some people are taken aback the first time they suffer a default in their lending account, but defaults are something to be expected. If you could be sure the borrower would never default then lots of people would be willing to give them a loan at a better rate and you wouldn't be able to lend them money at such a high rate. Defaults can quickly kill the returns of your portfolio but you might be surprised how many defaults you can have and still be getting excellent returns.

You can use our Expected Returns Calculator to see what changes in default rates do to your expected return. Keep in mind this is a lifetime default rate. So 10% defaults means that after the entire term of the loan it would have defaulted 10% of the time.

Is it really possible to get 10%+ returns from peer lending?

Yes and no. Lending club advertises historical return rates for their riskier grade loans well above 10%. These returns are exaggerated for several reasons. You can read a more technical explanation here. In order to acheive returns close to what is advertised you'll have to do an excellent job of picking loans that are less likely to default either by using a loan choosing service like InvestInP2P.com or creating your own strategy. If you just invest in loans with no strategy, you aren't likley to get 10%, but your returns will likley still be competitive with the returns you could make in other investments. Additionally, if you have a large lending portfolio of diversified loans your volatility is likely to be much better than the stock market.

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(F and G loans not included because of insufficient historical data to make an accurate assessment.)

How should I choose which loans to invest in?

Choosing loans that are less likley to default will increase your peer lending returns. People have devised many strategies and theories about how to pick good loans. Most people use a filtering technique. This means they screen out certain loans that don't meet their criteria. For example, you might decide not to invest in anyone who has had a credit inquiry in the last 6 months. They use sites like lendstats.com1 which help you apply a filter and see what historical return you would have received if you invested in loans with that filter. 

Smart filtering will increase your returns but there are some serious issues with using filtering to predict future returns. Better accuracy can be acheived with more advanced statistical analysis or machine learning techniques like we use to make our loan picks here.

How do I get started investing?

The two most popular peer lending platforms are LendingClub2 and Prosper3. This site focuses primarily on LendingClub, but most principles of investing in peer lending apply equally to both sites. You can open account online with either site and transfer money directly from your bank account. LendingClub has just a $25 minimum investment so there isn't any reason you can't get now.

What about taxes? 

One of the drawbacks of peer lending is that investing returns are considered ordinary income when filing your taxes. This means that you will be taxed your normal marginal interest rate on any peer lending income. This also means peer lending is a great place to put tax advantaged savings. Both Prosper and LendingClub offer IRA account options. These accounts have a higher minimum balance ($5,000) but are well worth the tax savings.





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