|Used with permission|
One thing I learned about when reading financial planning and investment blogs was peer-to-peer lending. Basically, this is a process whereby investors loan money to people seeking unsecured personal loans. It is a process that cuts out what we consider the normal middleman on such an occasion, the bank. The borrower, who must have a good credit rating, applies at the website of the peer-to-peer lender (I use Lending Club; Prosper is the other big name). After whatever quick review is done, I'm guessing by computer, the loan is listed on the site, with the listing giving some information about the borrower, the amount desired, and the proposed interest rate. At that point investors (the lenders) can agree to lend money to the borrower, and they do so in increments of $25.00. In other words, you may want to borrow $25,000. I (and other investors) decide whether we think lending you money is a good investment, and then decide how much to lend you--and the most common amount for small investors is the minimum, $25.00. The loan goes through the underwriting process, and the information on the application is checked for accuracy. Once everything checks out, and once enough people have committed to the loan to provide the funding requested, the loan is issued (and they are not guaranteed to be issued; at least a third of the loans I have selected have not been issued, either because Lending Club decided not to complete the process or because the borrower decided not to do so. I've read that over half the applications are rejected). At this point Lending Club takes a commission from the borrower, so the full amount of the loan is not disbursed to him/her. The attraction for borrowers is that these loans, at somewhere between 7.14% and 25.99%, have lower interest rates than credit cards or other sources of unsecured loans.
With any investment, you have to look at the risk vs. the reward. The main risk with peer-to-peer lending is that the borrower will default and not pay all or part of the loan. Since the loan is unsecured, Lending Club's recourse is limited. According to historical data (which you can download and crunch to your heart's content), the average interest rate on their "A" rated loans was 7.73%, however the average rate earned on "A" rated loans, after factoring in defaults and fees was 5.34%. You can see all the data here. There is some "interest rate" risk--risk that interest rates could rise so the "high-paying" note you are holding could turn out to be low-paying compared to what is currently available. Still the risk of that is lower than with a bond because instead of all the principal being repaid to you at the end of the loan term, you get a small amount back every month. The final risk is a liquidity risk--the chance that you won't be able to get your money when you need it. Lending Club isn't the place for money you may need within a couple of days. If you need your money within a week or two, you may have to sacrifice some principal to get it, but there is an active secondary market for the loans, so you should be able to get most of your money is a relatively short time. I'll talk more about that secondary market in another post.
After reviewing all the information I could find about Lending Club, I decided to become an investor. Since that time, I have spent a lot of hours "playing with my money" and I decided I would blog about my experience. Stay tuned for further posts in this series.