With the Federal Reserve keeping target interest rates near zero, consumers are becoming increasingly disappointed with the interest rates being offered by traditional “high-yield” savings accounts and are looking for investment options that will offer them higher-rates of returns. Many have looked into lending their money to people instead of banks through peer-to-peer lending brokers such as Lending Club and Prosper.com to receive interest rates well above 10%, but does Lending Club compare to saving with a traditional CD or a high-yield savings account?
Interest Rates
When considering interest rates, creating a diversified loan portfolio with Lending Club or Prosper will offer a much better rate of return than what one would receive with a high-yield savings account. Currently banks are offering interest rates between 1.30% and 2.30% APY. Lending Club investors have averaged 9.64% APY during the last two and a half years and Prosper.com investors are averaging 7.06% APY.
If interest rates were the only consideration, making loans to people through peer-to-peer lending institutions would win hands down, but investors also have to factor in risk. With a high-yield savings account, investor’s returns are guaranteed to them by the full faith and credit of the Federal Government through the FDIC.
By lending small amounts of money to a large number of people, your interest rate is wholly dependent upon people repaying their loans. Lending Club and Prosper have been able to minimize this risk by spreading out your investment risk to many different borrowers. Although there’s going to be a percentage of borrowers that do not repay their loan, somewhere in the 1-5% range, overall it can still be much more lucrative to loan to individuals through these peer to peer lending institutions than it is to put your money into a bank.
What about Liquidity?
With a high-yield savings account, one can withdraw their money from the bank with no penalty. With most CD’s, there is usually only a relatively small and painless penalty to take out your funds and turn them into useable cash. With Lending Club and Prosper, it’s much more like you’re investing in a certificate of deposit than with a traditional savings account where you can take the money out right away.
Typically, investors hold the loans that they make through the end of their term. Lending Club has developed an innovative solution to allow lenders to get out of their loans though. The company has partnered with FOLIOfn to develop a note trading platform that allows individuals with Lending Club accounts to buy and sell their loans.
Other Considerations
With a savings account or CD, you can deposit your money and never think about it again until you want to take it out. With Lending Club or Prosper, you have to individually choose loans or have them chosen for you with a matching system. There is definitely more leg work involved with peer-to-peer lending sites, but the extra work may be well worth the reward of much higher interest rates.
The Verdict
Services such as Lending Club and Prosper should not replace your high-yield savings account for short-term savings that may need to be liquidated within a period of a few months, but if you have some savings that you would like to invest for 3 years or longer, using sites such as Lending Club and Prosper can be a great way to get a much better rate of return on your money than through a traditional savings account or CD.
Update 10/8/2009: As many commenters have pointed out, the 7.06% average interest rate stated about Prosper.com is from Prosper’s own data. Many have questioned the methodology behind this interest rate and have provided links to alternative calculations which paint a much more grim picture of Prosper.com’s performance data.
