“If you haven’t heard of Peer to Peer Lending you are missing out on what is turning to be a very hot investing opportunity.”
Jeff Rose, The Huffington Post

businessman giving moneyIf you’ve read our blog for long, you’ll know we don’t recommend typical financial strategies. We’re not impressed with qualified retirement plans with guaranteed fees and future taxes (but no guaranteed gains), a stock market that seems to be increasing in volatility, or professional money managers who often can’t outperform monkeys, cats, or dartboards.

But we ARE outright evangelists for the alternative investments (outside the stock market) that DO work for our clients. And one that we recommend for consideration to some of our clients is Peer Lending,  also called peer-to-peer lending, P2P lending, or simply P2P for short.

What is Peer Lending?

Peer Lending is simply people lending money to other people online through peer lending websites. It has proven extremely popular both with people looking for loans below bank rates, and investors wanting to earn a competitive rate of return on their money for either growth or cash flow purposes.

Essentially, P2P lending cuts banks out of the financing equation and lets both borrowers and lenders benefit. The graphic from Lending Club below illustrates this:

Peer lending vs. banks chart

The first peer lending platform was Prosper,  which has been connecting borrowers and lenders since 2006. Still going strong today, Prosper is second in volume only to LendingClub.com.  Prosper has funded a billion dollars in loans to date, with average seasoned returns running close to 9%. LendingClub.com facilitated over $791 million in new loans in just the first quarter of 2014.

Dozens of newer peer-to-peer lending sites continue to pop up, along with crowdfunding sites such as Kickstarter.com,  which are often used to raise money for various projects and causes in exchange for gifts or rewards to funders, like personal mini-PBS-style donor drives. Newer equity crowdfunding sites such as AngelList.com  are even starting to match-make angel investors (who want more than a t-shirt for their investment) with companies seeking start-up capital.

The options are nearly endless, yet for individual investors seeking reliable cash flow or growth, the proven route is clearly loaning to borrowers wanting fixed-rate-and-payment loans on peer lending sites such as Prosper.com.

How Peer Lending Works

The potential borrower agrees to a credit check and (in most cases), discloses their debt-to-income ratio. They specify the purpose of the loan and apply for the amount, ranging from $2k to $35k. The peer lending platform evaluates their application and assigns what amounts to a credit risk score, assigning a letter grade (from AA to E) and an Annual Percentage Rate or APR deemed appropriate to the level of risk.

In the early days, peer lending companies didn’t set high enough standards and didn’t adequately communicate risks to investors, which gave peer lending a shaky reputation, but standards and rankings have gotten much more refined. Now APR’s for borrowers vary from less than 7% all the way up to 25%, based on risk, and most loans are simply rejected.

Lenders can protect their interests in many ways, such as buying many different loans in increments as small as $25. For instance, if a lender has 1,000 loans and if 30 of them default, they would lose 3% of their portfolio (less payments already made), while the remainder of the loans continue performing, many at double-digit interest rates. (If that sound like a lot of defaulting, consider that when you purchase bond funds and other similar investments, there are always defaults, you just don’t know about them!)

Peer Lending Returns

The rates of return from peer lending have proven to be very attractive to investors, especially when compared with other cash flow vehicles. Of course, there are no guarantees, but many investors feel safer with a peer lending portfolio than with the unpredictability of a stock market that plunged nearly 50% just a few years ago.

Investors often report returns of 10% or higher, and the websites of Prosper and Lending Club report average returns closer to 9%. Even a Forbes.com article asserted, “Looking for 10% Yields? Go Online for Peer to Peer Lending.”

Results and risk varies as the “A-rated” loans earn lower returns and have much lower default rates. Higher risk loans earn more interest, yet more borrowers default on the loans. The chart below illustrates how risk and return operate in the major peer lending platforms:

peer lending returns chart

There are different strategies and philosophies on how to increase returns and/or reduce risk, which we will explore next week when we interview a very successful young peer lending investor who also teaches others how to maximize their returns!

Who are the Borrowers and Lenders?

The average borrower has a credit score of about 700 and is looking for a 3-5 year fixed-rate loan. Over half are seeking loans for the purpose of refinancing or paying off higher rate credit cards and loans. Home improvements rank a distant second for intended use of funds, followed by things such as weddings, vacations, purchases of cars and other major expenses, and small business loans. Oftentimes these borrowers can find financing elsewhere, but they prefer to use peer lending for lower interest rates.

Lenders range from do-it-yourself individual investors to smaller institutional lenders such as retirement funds. Some investors hand-select each loan, others invest larger amounts using software that may not be as selective, but can “pounce” on available loans more quickly.

Word on the street has it that some U.S. and European banks such as such as Citigroup, Barclays, and Deutsche Bank are planning to launch their own P2P ventures geared to market to institutional investors. Critics say this would compromise the very “peer-to-peer” idea that fueled the movement in the first place, and neither lenders nor borrowers are excited to compromise their savings or profits through the institutions that peer lending was designed to side-step.

Volume-wise, P2P sites are microscopic compared to institutional lenders such as banks and financing companies, but increasingly, the demand for loans is having a hard time keeping up with the supply of available cash from eager investors. The explosive growth of P2P – loan volume has been doubling every 9 months – indicates that peer-to-peer is here to stay.

Even bank employees are getting in on the game, apparently much to the chagrin of bank executives. In January, a memo to Wells Fargo employees asking them to refrain from lending on peer lending sites was leaked. Supposedly, “ethics administrators” had determined that “for-profit peer-to-peer lending is a competitive activity that poses a conflict of interest.” However, in March, the bank officially announced that was NOT their policy.

Is Peer Lending for You?

Peer lending is not for everyone, but it’s worth consideration IF:

  1. You already have your life insurance and your emergency fund / opportunity account well-funded. You’ll want at least 6 months, ideally 12 months of expenses available to you in safe and liquid assets, typically starting with a savings account and then growing it larger with whole life cash value.
  2. You are willing and able to be an involved and informed “do-it-yourself” investor. This is not a set-it-and forget-it strategy, at least, not if you wish to maximize your profits.
  3. You can start with small – modest amounts of money and build as you go. If you need a place to invest $100,000 or more, peer lending may not be a good fit (due to the relative difficulty in obtaining enough loans to adequately diversify.)
Maximize Your Profits with Peer Lending!

Next week, we’ll be back with tips from a successful peer lending investor on how he has maximized his earnings far beyond the “typical” reported returns of 9-10%! (Now posted: “Peer Lending Investing Success Story.”)

Want more cutting edge news you WON’T hear from “typical” financial advisors? Get on our list to receive our free Prosperity on Purpose ezine and get our Prosperity Accelerator Pack as a bonus!

Want to explore peer lending further? Watch this short CNBC segment on peer lending:

LISTEN: The Truth About Peer Lending Investing on Guide to Financial Peace Radio.

Some of the links in this post are affiliate links that could potentially lead to a small commission. We never recommend anything for the sake of a commission alone, but if you find our information helpful and wish to investigate being a peer lending investor, we invite you to use our affiliate link for Prosper.com