Understanding Peer-to-Peer Lending Risks

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By Pinyo, on February 16, 2009

A while back, I provided a brief introduction to peer to peer lending. I also mentioned that there are risks involved. In general, social lending has different set of risks from that of high yield savings, certificates of deposit, or the stock market. In the simplest sense, the risks involved when investing in person to person loans is most similar to investing in bonds.

How Is Peer-to-Peer Lending Different From Other Investments?

When you lend money in a social lending network, you are giving a sum of money to your borrowers and in return they pay you back the principal, plus interest, over the term of the loan (usually 3 years unless they pay off the loan early).

Default Risk

Unfortunately, lending comes with what is known as default risk. For example, one or more of your borrowers could stop paying back their loan for whatever reason. At this point, the loan becomes late, then it goes to collection, and finally it get charged-off — unless the borrower decides to start paying again.

This is what is known as default risk. When your borrower defaulted, you loose that money for good. So be careful about who you’re lending to.

Principal Is Not Guaranteed

Due to the default risk, it’s possible for you to lose some or all of your investment. For example, you deposit $2,500 into your Lending Club account and loan $25 to 100 borrowers. Depending on when the defaults occur, you could lose as much as $1,000 if 40 borrowers don’t repay their loan.

Not FDIC Insured

When you put your money in a high yield savings or a CD, your money is federally insured up to $250,00 if your bank is an FDIC member. You are guaranteed your money back even if the bank goes out of business. This is not true with social lending networks and you have to read carefully about what happens if the network goes out of business. In case of Lending Club, they will pass the loans over to Portfolio Financial Servicing Corporation (www.pfsc.com) for PFSC to take over loan servicing.

How To Minimize Risks When Investing In Peer-to-Peer Lending

Fortunately, there are ways to minimize risks involved with peer-to-peer lending. Here are a few things that I look for in my borrowers:

  • Good credit rating
  • Low debt-to-income ratio (DTI)
  • Low credit inquiries
  • No delinquencies
  • Smaller loan amount

Additionally, here are a few more tips:

  • Diversify your portfolio by lending the minimum to many borrowers, as opposed to lending a large amount in a few loans.
  • Don’t be distracted by sob stories and sexy photos
  • Start small while you’re learning

You should also consider this investment as part of your overall strategy. Personally, I don’t recommend allocating more than 5% of your total asset to peer lending.

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Peer-to-Peer Lending, investing in bonds, DTI, fdic member, Investing

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Pinyo
Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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13 Comments

  1. gravatar
    the weakonomist
    February 16, 2009, 13:11

    I’m yet to take the plunge into actually lending any money through this system, but I will probably treat it as a donation. Give $20 to some cause I think is worth it (debt consolidation perhaps) and just treat getting my money back as a pleasant surprise.

    I hope this program gets more and more successful, they are really doing a good thing.

  2. gravatar
    Craig
    February 16, 2009, 16:17

    Way to establish some risks involved and way to help out your cause. I am just learning about peer to peer lending and didn’t realize how the system worked. It seems tough because there are no guarantees or ways to force someone to pay you back. Are their any ways they regulate?

  3. gravatar
    Pinyo
    February 16, 2009, 16:26

    @Craig – Just like other kind of debt, if a borrower doesn’t pay, the social lending network send collection agency after him/her and report any delinquency and default to credit bureaus. However, the the borrower doesn’t care about his/her credit score and credit history, then there’s not much protection for you as a lender.

  4. gravatar
    Craig
    February 16, 2009, 16:35

    @Pinyo Sounds like a good way to try to get better rates. What are the typical rates and how long do you usually lend out for? Would you recommend this over say an ING account?

  5. gravatar
    Chiko777
    February 16, 2009, 21:46

    I am suppose to be trying the whole P2P lending pretty soon. Thanks for the advice, I will be watching out for these things.

  6. gravatar
    Pinyo
    February 16, 2009, 21:57

    @Craig – With Lending Club, you start as low as around 7% and as high as around 20% (https://www.lendingclub.com/info/rates-and-fees.action). However, I only focus on A rated borrowers so it’s around 7-9%. I would only invest what you can spare to lose, and this should not replace your regular savings in a high yield savings account — i.e., ING account. The standard lending term is 3 years, so that’s another key difference — i.e., liquidity.

    @Chiko – Sounds good. Just start out slow and don’t put all your eggs in one basket.

  7. gravatar
    RobG
    February 17, 2009, 14:30

    Great job educating your audience on the wonders of investing in P2P lending. I particularly enjoyed how serious you were about the “sexy photos” observation.

    Rob

  8. gravatar
    Pinyo
    February 17, 2009, 14:34

    @RobG – I should note that there’s no sexy photos on Lending Club. You’ll have to go to other peer lending networks for that.

  9. gravatar
    BColeman
    February 17, 2009, 15:04

    Good article! Peer-to-Peer Lending is a great way for lenders (investors) to diversify their investment portfolio. I am excited to see the buzz of Peer-to-Peer Lending (it’s even started to hit mainstream media). I appreciate you educating your audience, but isn’t a 40% default rate a bit high… ha! With P2P companies like Lending Club & soon to come… IOU Central only allowing high-credit, more qualified borrowers… that default percentage seems high. With that said… Good article!

  10. gravatar
    Pinyo
    February 17, 2009, 15:07

    @BColeman – 40% was a made up number to make a point about defaults being real and serious risks. I supposed I could use a more realistic data, but I was just trying to make a point. :-)

  11. gravatar
    BColeman
    February 17, 2009, 15:10

    Understood… I am just excited to see P2P Lending get this attention (and education). If done right… it could revolutionize personal lending (and borrowing). Thanks for the article! B

  12. gravatar
    Pat Engesser
    September 3, 2009, 2:56

    Just happened upon this site. My husband and I are 60 and 62, respectfully. We have no true retirement savings. Would 3000.00 in the peer to peer be so very stupid for us? I have a little money to invest, but interest rates are minimal. Thank you.
    Pat Engesser

  13. gravatar
    Pinyo
    September 3, 2009, 9:27

    @Pat – I wouldn’t recommend getting into peer to peer lending until you have all the basics cover — i.e., debt paid off, emergency fund in place, etc. Also, I wouldn’t give P2P investing priority over traditional investing in stocks and bonds.

    Currently, there’s an excellent discussion entitled:
    I am 60 do not have any retirement saved what should i do exactly?     on Moolanomy Answers. Please take a look.

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