Peer to Peer Lending: Cautions and Considerations

lendingclubPeer-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 LendingClub, 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 LendingClub 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: LendingClub and Prosper are both as transparent as it gets, and you can check out the default rate for any credit grade before you fund an easy repayment short term 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 LendingClub 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 LendingClub loans, however, it will finally be doing something smart.

If you interested in investing in P2P, please read our LendingClub Review.