Peer-to-peer (P2P) lending has been getting an awful lot of attention these days. The big two P2P lenders in the US are Prosper and Lending Club, respectively. Here’s how it works. Borrowers post a public request for a loan and lenders pitch in to fund it. Once the loan is fully funded, the proceeds are released to the borrower. Then, a structured repayment plan doles out monthly payments plus interest and any late charges incurred to lenders.
The best part about P2P lending is that the average rate of return beats most traditional investments with a stick. I have a nice chunk of change set aside and I’ve already opened a Lending Club account. I’ve been doing my homework in anticipation of funding my first loans using the platform, and I’ve come across some repeated themes that I’ve come to consider “best practices” for first-time lenders to keep in mind.
Diversification is Vital
You are a lender when you fund a P2P loan. This means the risk is much greater than investing in something guaranteed like a CD or a bond. However, you can minimize this risk into virtual nonexistence by diversifying the loans in your portfolio.
When you choose loans to fund, you’ll get the specs on the applicant first. Factors such as length of work history, credit grade, and public records are all on display. For higher-risk applicants, the interest rate you’ll earn is much higher, but so is the rate of default. Good news: Lending Club and Prosper are both as transparent as it gets, and you can check out the default rate for any credit grade before you fund a loan.
Some investors I’ve read up on have posted great returns on portfolios of loans made up of borrowers with terrible credit ratings. However, these loans are still young and some are already late, indicating possible defaults down the line. Other lenders stick to a more conservative strategy – they stay with the A and B borrowers. The returns are lower, but the rates still outperform CD interest rates by a margin of 3 to 1.
From what I’ve seen after spying on multiple investors, the best way to play things is to fund lots of loans with similar numbers at $25 a pop. That way, defaults won’t hurt unless they happen en masse. This is also unlikely if you do as I plan to and fund loans with a mix of all credit grades, weighted more heavily toward A and B applicants.
Keep Your Money Working for You
I also plan to wave buh-bye to my money after I’ve funded my Lending Club account. What I mean is that I’ll be immediately reinvesting all the loan repayments into new notes. I don’t want any money sitting dormant in my account – I want every single dollar working to earn me more interest at all times.
I’m nervous but excited. When I have money in savings, I inevitably spend it on something stupid. Once my dough is tied up in Lending Club loans, however, it will finally be doing something smart.
If you interested in investing in P2P, please read our Lending Club Review.
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I just posted a screenshot of one year data for my investments in Prosper. I also just opened a Lending Club account. The most important factors are diversification. DO NOT INVEST MORE THAN $25 (or $50) with one lender under any circumstances. AAAMPblog, it's unlikely that all investors will default at once causing a total loss of principle. It took me four years of consideration before I decided to invest with Prosper. I have also spoken with the founder and read their SEC documents (not for the faint of heart). That said, NEVER INVEST IN ANYTHING YOU ARE NOT COMFORTABLE WITH. If you cannot stand to lose any part of your investment, avoid stocks and corporate bonds and stick with government securities and cash.
Peer to Peer Lending is a huge accident waiting to happen. I'm not saying that it's not appropriate for a small % of a portfolio IF the investor understands the risk, but I believe few really do. These are at best, the equivalent of Junk Bonds, even the highest rated loans. There is almost zero history of how they will perform in a bad downturn. Defaults could be much worse than anyone I've talked imagines. Buyer beware!!!! Your principal is at risk; all of it!
I have been thinking about P2P lending more often as of lately. The main reason is the one that you highlighted... to avoid having money sitting in my savings account. It may be a little more risky, but it's better than sitting in a low-interest account.
Nice article Nell. I have been investing with Prosper for almost 3 years and have found your advice on diversification to be the most important ingredient for success. The second ingredient is to loan to borrowers who have had a previous Prosper loan and demonstrated consistent on time payments. I now have over 1,100 notes at $25 each and have averaged a 14% ROI.
Best of luck! I'll be interested to see what happens. I've always been a bit skeptical of these programs but they seem to work out for the most part.
@Kent Just out of curiosity, have you funded the same person more than once? I guess my real question is, are there a lot of repeat customers?