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How To Avoid The 3 Biggest Risks In Peer Lending

Last Updated: December 7, 2017 BY Michelle Schroeder-Gardner - 25 Comments

Disclosure: This post may contain affiliate links, meaning I get a commission if you decide to make a purchase through my links, at no cost to you. Please read my disclosure for more info.

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How To Avoid The 3 Biggest Risks In Peer LendingHello! Here is a post from a blogger friend. Peer lending is something I have been interested in learning more about, so I thought this topic would be perfect for my readers. Enjoy! 

If you haven’t heard about the peer lending revolution yet, you soon will. Both companies in the space, Prosper and Lending Club, are issuing more than $100 million in new loans every month.

The revolution in peer lending is opening a new world to investors but many are being caught off guard. Know the risks and resources before investing in online loans and you might just find one of your favorite investments.

If you are interested in joining Lending Club, here is the link.

 

Peer lending is taking the power from big banks

The first peer loans were made on Prosper nearly a decade ago but the movement has only just begun to gain momentum over the last year. It took Prosper over eight years to originate a billion dollars in loans. It took the loan platform just six months this year to originate its second billion.

Peer lending is the coming together of the online world and traditional lending. Borrowers fill out an application for up to $35,000 on a lending website, either Prosper or Lending Club in the United States. After a credit check and review, the application is assigned a credit rating and an interest rate.

The loan request then goes live on the website for investors to fund. Investors decide how much they want to fund in a particular loan, as low as $25, and in how many loans they want to invest. Once enough people choose to invest in a loan and it reaches its requested amount, the money is deposited in the borrower’s bank account.

The borrower makes regular payments to the lending website, as with any loan, and the website passes payments on to investors. The concept is nothing new, people have been investing in bank loans for ages but they’ve always had to go through the bank or a brokerage firm.

Peer lending is changing all that and connecting borrowers with investors directly.

 

Too much risk or just the right return?

High-yielding investments could not come at a better time for savers. Rates on government bonds pay next to nothing after inflation and you’re lucky to get the stock market’s 7% annual average, if you can avoid the next major crash.

The table below, constructed from data on peer loans through Prosper, shows the loss rate and return across the website’s seven risk ratings. Averages across the categories and across all loans are quite good, especially compared to other types of investments.

Prosper default and returns - How to Avoid the 3 Biggest Risks in Peer Lending

But that doesn’t mean investing in peer loans is without risk. Of those I have interviewed and from my own personal experience, three common mistakes seem to plague new investors in peer lending.

 

Investor risk #1: Double-digit returns? Sign me up!

Probably the most common mistake is that new investors see the potential for returns approaching 30% in the most risky loans and leap into the category before they understand the danger. Dreams of sandy beaches and Mai Tai cocktails quickly turn to angst when loans in their portfolio start defaulting.

There is a reason why those loans are in the high-risk category! These are borrowers with missed payments or worse and the possibility for default is high. One look at the table above should prepare you for defaults on one-sixth the loans in the HR category.

You absolutely must understand your own tolerance for risk before investing in peer loans. If you get skittish at the first sight of losses, then you’re probably better off investing exclusively in the safest categories. While there will be an occasional default in these as well, the frequency is much lower. If you can ride out a few bad loans and look at the bigger picture without stressing out, there is no reason you would not be completely comfortable investing in higher-risk loans. Notice that even after higher defaults in the HR category, the average return is still very high compared to the safest categories.

 

Investor risk #2: Diversification is just for stock investors, right?

Many jump into peer lending and ‘test the waters’ with a few loans before they really give the investment a chance. Investing in less than 30 loans is not investing at all but gambling.

If you want to gamble with your savings, Las Vegas is a whole lot more fun.

I understand the idea that investors want to play it safe and not commit too much money to peer loans before they understand what can happen. Even investing the minimum of $25 each across 20 loans translates to a $500 commitment. The problem is, if even one of those borrowers defaults, you are already down 5% from where you started.

Unless you have a crystal ball into the realm of credit and loan defaults, you need to spread your investment across enough peer loans that a small number of defaults will not completely wreck your return. I normally recommend investing in at least 50 loans so that each only accounts for roughly 2% of your total portfolio.

 

Investor risk #3: The Dartboard Strategy

This is really the extreme opposite of the previous risk and probably my biggest pet peeve of advice in peer loans. You will find websites that recommend investing across hundreds or even thousands of loans. You could not possibly analyze the criteria in more than a few hundred loans so this strategy is basically just investing across all loans in a category or across the site. While this kind of index-investing strategy is popular with stocks, you risk leaving a lot of money on the table by using a dartboard approach.

There are factors that can be used to pick loans that can produce higher returns than the average across the platforms. I recently interviewed one investor that turned early losses to an five-year annualized return of 14% and a gain of $9,000 by changing his strategy for picking loans.

Don’t get me wrong, you absolutely need to diversify your portfolio across many loans. Putting all your money into a few loans risks chaos if just one loan defaults. Contrary to what some would say, you can achieve all the diversification you need with about 100 loans. While diversified, this still gives you the opportunity to pick loans based on criteria that can lead to higher returns.

As great as the potential is for investors, peer lending is opening new opportunities for borrowers as well. More than three-quarters of peer loans are being used to consolidate high-rate loans and help dig people out of a vicious cycle of debt. The revolutionary idea is not without its risks for borrowers as well. Fortunately, blogs like peerloansonline.com exist to educate borrowers and investors to make your experience in the world of peer lending a success.

Author: Joseph Hogue, CFA. PeerFinance101 is all about sharing our stories of personal finance challenges and success so we can learn and meet goals together. Share anything from living with debt, investing, peer lending or any other personal finance topic.

Are you interested in peer lending? Why or why not? How are you investing your money?

 

If you are interested in joining Lending Club, here is the link.

 

Side note: I highly recommend that you check out Personal Capital if you are interested in gaining control of your financial situation. Personal Capital is very similar to Mint.com, but 100 times better. Personal Capital allows you to aggregate your financial accounts so that you can easily see your financial situation. You can connect accounts such as your mortgage, bank accounts, credit card accounts, investment accounts, retirement accounts, and more, and it is FREE.

 

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25 Comments
Filed Under: Extra Income, Retirement Tagged With: Extra Money, Investing, Retirement

About Michelle Schroeder-Gardner

Michelle is the founder of Making Sense of Cents, a blog about personal finance and traveling. She discusses how her business has evolved in her side income series. She paid off $40,000 in student loans by the age of 24 mainly due to her freelancing side hustles. Click here to learn more about starting a blog!

Comments

  1. Cyrel says

    February 27, 2015 at 3:50 am

    I think I still need to study on peer lending more. But thanks for being straightforward in telling us what to avoid.

    Reply
    • Joseph Hogue says

      February 27, 2015 at 7:46 am

      Thanks for the comment Cyrel. Yep, it can take a little while to get used to the new form of financing. Let me know if you have any questions.

      Reply
  2. Anna says

    February 27, 2015 at 4:56 am

    This is really interesting stuff. I’m not sure if there are any companies doing this in the UK yet; I’m sure there must be.x

    http://thecornishlife.co.uk

    Reply
    • Joseph Hogue says

      February 27, 2015 at 4:23 pm

      Anna, actually the UK is even further along that the U.S. in alternative finance and is doing some great things with p2p and crowdfunding. Check out Zopa for peer lending options.

      Reply
  3. Mrs. Maroon says

    February 27, 2015 at 5:57 am

    Thanks for sharing some strategy ideas. I think peer lending is quite unique and potentially a great way to diversify holdings. But I’ve never taken the time to educate myself on the details or how to go about developing a strategy. Good stuff here!

    Reply
    • Joseph Hogue says

      February 27, 2015 at 7:48 am

      Thanks Mrs. Maroon. Fortunately, most of the big peer lending platforms like Prosper and Lending Club automate a lot of the process and offer tutorials on investing.

      Reply
  4. Gina Horkey says

    February 27, 2015 at 7:52 am

    I hadn’t heard a lot about peer lending. Thanks for sharing and giving some advice on how to do it right.

    Reply
  5. Amy says

    February 27, 2015 at 7:56 am

    Thanks for the information. This is a topic about which I know very little. I don’t think it’s for me at this point, definitely something to think about in the future.

    Reply
  6. Fervent Finance says

    February 27, 2015 at 8:09 am

    Peer lending is all the rage right now. Although I haven’t dove in yet, I’ve found many useful articles online how to search for proper loan candidates in an effort to minimize defaults. Great tips!

    Reply
  7. Ben Luthi says

    February 27, 2015 at 10:21 am

    It’s definitely a great opportunity for both borrowers and lenders. And while the regulation is still in its infancy, it seems as if there are enough controls in place to minimize risk as much as you want to.

    Reply
  8. John says

    February 27, 2015 at 11:08 am

    I use to participate in peer to peer lending through Prosper but it has been over 5 years since I stopped. At the beginning everything was great for me and my loans. I diversified across 20 different loans always AA, A, or B. I found that even a lot of AA borrowers would default. I ended up earning a small profit but nothing like I thought it was going to be.

    Then the state I lived in blocked its residents from participating in peer to peer lending and I could no longer invest. I am not sure if they still ban P2P or not?

    I still think there is a place for P2P, but I prefer to invest my money in dividend stocks.

    Reply
    • Joseph Hogue says

      February 27, 2015 at 4:27 pm

      P2P went through a really rocky period there around the financial crisis. The loan rating software really wasn’t developed very well. Default rates were much higher than estimated and the government shut down the bigger players for a while to check it out.

      Leaps in software and rating have been made over the last couple of years and defaults follow a more predictable curve. It’s too bad that stumbling blocks out of the gate turned a lot of people off the opportunity.

      Thanks for the comment.

      Reply
  9. Dawn says

    February 27, 2015 at 11:10 am

    Interesting. I have seen all the ads on credit karma and such for borrowers but I am very curious how it works for lenders. Am I crazy but think this is awesome for investing? Your idea to spread it among 100 is great. But how to you come up with criteria to decide? Would love to hear more in how you pick wisely or wiser than just here,here,here. I am studying all this so when my debt is gone I can jump right in!

    Reply
    • Joseph Hogue says

      February 27, 2015 at 4:31 pm

      Thanks Dawn. You definitely need at least 100 loans to spread your risk around. As for criteria, I look at a fairly small list to keep things simple but it helps me get a slightly lower default rate and a percent or two above the category averages.

      I have a couple of posts on the blog PeerFinance101 under the peer lending category that describe my criteria-picking strategy. It mostly revolves around borrowers with successful loans in the past and no credit inquiries.

      Thanks for the comment.

      Reply
  10. Melane @ Good Job Mom says

    February 27, 2015 at 11:16 am

    Really interesting! I had no idea that this type of loan was available, I find it intriguing. Thanks for a primer on the basics, you made the subject easy to understand.

    Reply
  11. Christy Peeples DuBois says

    February 27, 2015 at 4:37 pm

    I have read some about the peer to peer lending. You explained it exceptionally well. One of my initial thoughts was/is how will this affect the lending institutions with its growth. I try to look at the overall picture and just curious and interested. Thanks.

    Reply
  12. Rust says

    February 27, 2015 at 6:55 pm

    Another informative article, thanks. I learned a lot about peer lending, something I’d not heard of before now.

    Reply
  13. nicole dziedzic says

    February 27, 2015 at 7:05 pm

    Awesome useful information, great learning experience, I love reading your posts, I feel so informed!

    Reply
  14. Pamela Gurganus says

    February 27, 2015 at 8:59 pm

    This was a lot of information! I’m going to read and re-read it again. This is something everyone can benefit from knowing. Thank you for sharing this!

    Reply
  15. Jason @ Phroogal says

    March 1, 2015 at 2:22 am

    I’ve been working with credit unions to get them back to peer-to-peer lending. They are the original pioneers in the space. I’ve been wondering if credit unions could allow actual members to choose which loan to fund from other members.

    Reply
  16. Sandy Klocinski says

    March 1, 2015 at 1:26 pm

    Great post. I am intrigued by the concept. I think it’s a great way to go for borrowers.

    Reply
  17. Bill says

    March 1, 2015 at 1:38 pm

    Hey Joseph good post. Just to add, peer lending can yield you double-digit returns. The only disadvantage its that its not available in all states.

    Reply
  18. Michelle L says

    March 1, 2015 at 7:23 pm

    As they like to say, with all investment there is risk…

    Reply
  19. Craig McLarty says

    March 9, 2015 at 10:41 am

    Interesting concept.

    Reply
  20. Joanne Arcese says

    March 9, 2015 at 3:30 pm

    I think this was an excellent article straight foward with excellent advice.

    Reply

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