How to Make Money with Peer-to-Peer Lending

Posted in Investments • September 23, 2010

peer-to-peer

When the going gets tough, the tough get resourceful, and the current economic doldrums have proven that adage true once again.

As banks continue to fight for survival the credit market has dried up to almost nothing, forcing people to find new ways to get loans. One creative approach that’s making the financial world sit up and take notice is peer-to-peer, or P2P, lending.

How Does Peer-to-Peer Lending Work?

This bank-free, Internet-driven process involves individuals investing their money into peer to peer loans. The way it works is this: A person invests, say, $5,000 into a P2P lending site, such as Lending Club. He or she then reviews all current loan requests on the site, which come with the applicant’s credit score and other relevant data concerning their financial history and viability.

If the investor feels confident in the borrower’s credentials, then he or she will fund the P2P loan — either fully or partially — with their investment. (Many

lenders like to spread the risk around by funding loan requests in smaller amounts — say, $25. Borrowers, therefore, could get a loan floated by many different investors.)

Borrowers like the interest rates, which are often much lower than those offered by banks and credit card companies, and P2P lenders are claiming returns on their investments that are far higher than those of traditional investment vehicles, such as money markets and CDs.

Varied Interest Rates

However, as tempting as the return rates may be, peer-to-peer lending comes with risks that the curious need to be aware of.

When compared to the interest rates earned on other investment options, such as CDs, money markets, and stocks, P2P lending seems very promising. For example, Lendingclub.com, one of the fastest-growing “personal lending” institutions, advertises average returns of 9.67%. That’s a phenomenal figure when compared with the average return from CDs (currently an anemic .91% for a 1-year note – the lowest recorded average since 1983), money markets (1.79%), stocks (down 38% from last year, according to Standard & Poor), and of course, the still-troubled real estate market. (Read our comparison of peer-to-peer lenders here.)

Clearly, these numbers are very general, and some sectors and sub-sectors of the financial economy are performing better than others. Nonetheless, peer-to-peer lending is generating enough success stories that more and more investors are taking an interest in it. Current P2P loans total around $500 million, a number which is expected to explode to $100 billion by 2012.

Information listed may be out dated.  Please visit our Personal Loans page for up to date information.

The Risks of Peer-to-Peer Lending

While P2P lending is growing by leaps and bounds, it has significant risks which an investor needs to be aware of. First and foremost, any money you put into a peer-to-peer fund is uninsured, so if the person you’ve loaned your money to defaults, you’re out of luck. That lack of security is going to be a deal-breaker for many people who want their money to be safe, regardless of the low returns they’re getting.

Additionally, peer-to-peer lending institutions are not insured by the FDIC, so even if you’re making money off your investment you could still lose it all if the peer-to-peer institution goes belly up.

Since peer-to-peer lending is so new, the current conventional wisdom on its long-term potential is extremely cautious interest. Most financial advisers are advising their clients to start making small investments in the personal lending market, and then watching the returns to see how the investment does.

One interesting take on his peer-to-peer lending experiences is offered by investment blogger WealthBoy.

He said he expects some of his investments in Prosper.com to be defaulted, but his investment strategy takes that into consideration.

“As long as you can outpace your defaults with your average interest rates, you can make money investing in Prosper loans,” he wrote in one blog post.

Keeping the bulk of an investment portfolio in safer options, like CDs, money markets, and blue-chip stocks, is still the broker’s mantra, especially now that the stock market and economy in general have begun to show real signs of recovery. Additionally, the real estate market may be nearing its bottom, making many people eager to snap up bargains in preparation for the return of demand.

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