When we lend money to our friends, we will typically hand them $20 or $30 and they will pay us back a week or two later and we won’t think much of it. If the person was willing to provide you a little bit of interest, you actually might make some money off the deal. What if you could take the idea of lending to your friends and repeat it hundreds of times to different friends from around the country. This is what two competing companies, Prosper and Lending Club are doing and many investors are making these person-to-person loans part of their investment portfolios.
When considering any investment, the primary considerations are the rate of return the investment provides and the amount of risk that is associated with the investment. You could go down to Las Vegas, play roulette at one of its many casinos, and put your entire life savings on black. It would provide a 100% rate of return on your investment if you won, but nobody does that because it involves far too much risk. When you factor in risk, it’s just not worth it. The same is true for other investments. You might have the option to invest in some hot new tech company that could potentially double or triple your money, but you might not do it because it’s a very risky venture.
When lending someone money, the primary risk that you face is the individual not repaying the loan. Lending Club and Prosper have done a fairly good job at minimizing their default rates by being more selective about who they lend money to. Individual investors can look at the borrower’s credit information, employment history, and reason for a loan. They can also ask the borrowers questions and decide whether or not the person is credit worthy. Lending Club has been able to minimize their default rates dramatically. Their best performing loans have default rates of just 0.5%. Their highest-interest loans for sub-prime borrowers have default rates of around 5.00%. By investing in a conservative portfolio, you can minimize the default rate to about 2.00%
So where should one consider peer-to-peer loans in their investment portfolio? One might consider them an alternate to corporate or municipal bonds. Instead of lending to corporations or municipalities, you are lending to people. The interest rates on person-to-person loans in many cases are much better than what one would receive from most corporate and municipal bonds.
Many of us have learned the importance of diversification in investments in the last 12 months. Individuals need a mix of stocks, bonds, real estate, cash and other investments to stay properly diversified. By lending money to individuals, you have yet another way to diversify your portfolio and improve your overall financial picture.
