It’s hard to get decent returns on cash these days. Banks are paying you virtually no interest on your savings, and then turning around and lending it to others at a substantial markup.
What if you could remove the bank from the equation and lend money directly to people looking to borrow?
That’s the idea behind peer-to-peer lending, which is now often called marketplace lending.
I became fascinated with this business model nearly a decade ago when Prosper.com launched. The service was kind of like an eBay for loans. People would post their story and why they wanted to borrow money, and lenders could fund their loans.
Unfortunately, Texas residents like me weren’t able to fund loans on these marketplaces back then due to state regulations. Earlier this year Lending Club, a publicly traded competitor, opened its doors to Texas residents looking to make loans. I decided to take the plunge…but the model has changed a lot from the early years.
How Peer-to-Peer Lending Works
P2P Lending essentially cuts out the bank as a middleman in loans.
Borrowers apply for a loan, lenders (you) choose which loans to fund, and a marketplace sits in the middle. The marketplace is kind of like a bank, but they take only a small fee for the loans.
The sales pitch is that both borrowers and people with money to lend do better than if they were to go through a traditional bank. This is born out by the fact that the majority of loans are applied for to consolidate debt or pay off credit cards at lower interest rates.
When a lender chooses to fund a loan, they don’t have to fund the entire amount. At Lending Club, for example, you can contribute as little as $25 per loan.
How to Lend
I’m writing about Lending Club because it’s the only large player currently available to me in Texas.
Getting started was fairly simple: just fund your account with a bank transfer and then start investing.
But how you choose to invest is interesting. Back when P2P lending started, lenders would scrutinize each loan, perhaps read about the borrower’s personal story, and then decide to make the loan.
That’s not really feasible anymore. Institutional investors got into the lending game on these marketplaces, using algorithms to spot and fund the ideal loans the moment they hit the market. Everyday Joe investors can still get in on these loans, but it’s a real pain. It can involve logging in multiple times a day to spot the best loans. You’re time is valuable, and if you factor in the work involved, it’s probably not worth investing one-by-one in P2P loans.
That leaves three options:
1. Use the marketplace’s automated investing tools. In this case, you tell Lending Club which types of loans you’ll fund and it funds loans on your behalf.
2. Use a third-party automated investing tool such as LendingRobot.
3. Invest in a P2P Fund such as the Prime Meridian Income Fund or Colchis P2P Income Fund. These funds are available to people even in states that don’t allow personal investing on the marketplaces, but they usually have high minimum investments ($500k+).
I chose to use Lending Club’s automated investing.
With automated investing, you select which credit grades you’re willing to invest in and your overall strategy and Lending Club takes it from there. You can also apply filters to the loans you’re making to further refine your lending.
As with any lender, there are two things that affect your returns: The interest rates and defaults.
Lending Club currently collects 5.32% to 28.99% on loans depending how how risky it judges the loans are. But you’re not necessarily better off just going after the higher-rate loans, because they’re more likely to default.
When you first start investing, your returns will be quite high. Over time as some people fail to repay loans, they will drop.
I’ve been investing for just a few months so far and none of my borrowers are delinquent…yet. So I’ve earned 13.03% so far. But Lending Club expects my long term results to be 5.5% to 8.3%.
That’s nothing to sneeze at in this market.
There are two main risks I see with investing in these loans.
First, default rates in the future could be higher than Lending Club anticipates. After all, it’s been a long time since the U.S. has seen a big downturn. P2P hasn’t been around long enough to really understand what will happen in the next downturn.
Second, interest rate risk. Lending Club loans are 36 and 60 month loans, and a lot can happen between now and then. This is a key drawback on these loans; you’re committing your cash for 3-5 years. (There is a secondary market for selling loan interests, but you might lose money to liquidate quickly.)
I’ll let you know how my loans perform over time.
In the meantime, if you want to learn more about this type of lending, check out the excellent site Lend Academy. And if you want a $25 bonus for opening a Lending Club account, drop me an email at andrew (at) upmoney.com.