I have been lending in peer-to-peer lending networks like Lending Club and Prosper for about ten years now. Today, I want to share with you some of the things I have learned, and you can decide if this is the right investment for you. For those looking for quick answers: yes, peer-to-peer lending is a legitimate investment, the risk level is about the same as high-yield bonds, and the returns level is about 4-7% per year.
How Peer-to-Peer Lending Works
In case you’re not familiar with peer-to-peer lending, these networks bring together a large number of lenders and borrowers. As an investor, you are the lender and have the option of lending as little as $25 to a borrower. If you have a large sum of money to invest, you can invest $25 in many loans (recommended), or invest more money in a few loans (not recommended). As a borrower, you can borrow as much as $40,000, and this amount can come from one lender (unlikely) or multiple lenders.
Here’s a nice image from Lending Club’s How Social Lending Works page.
Lending Club Historical Returns
On their website, Lending Club claims that it provides competitive returns at historical rates of 4% to 7% per year. My historical performance based on investing in 201 notes was at 5.06%, which is right in the range indicated by Lending Club.
As you can see from the chart, your portfolio performance will drop in the first 12 months as dead beat borrowers stop paying their loans. The returns do stabilize across the rest of the holding period.
You can click here to see more Lending Club Statistics.
Peer-to-Peer Lending Risks
Like any other investment, I must warn you that peer-to-peer lending is not risk-free.
When I started, I was enticed by the higher interest rates on higher risk loans (i.e., borrowers have poor credit ratings). This worked out fine initially, but I ran into more late loans and defaults.
For example, I had two defaults in my Lending Club account that amount to $45.38, which effectively wiped out my gain resulting in a -1.88% loss in 2008. I fared slightly better with Prosper, where I had three late loans, but no default.
Except for one loan, all of these late and default loans are subprime rated loans. So my advice is: Stick to prime-rated loans if you want to start investing in peer-to-peer lending networks. Lending to borrowers with excellent credit will not eliminate default risk, but it will significantly reduce that chance of losing your money due to defaults.
Holding Period Risk
Another important thing to realize is peer-to-peer lending is not a liquid investment. Borrowers have 36 to 60 months to pay back their loan, so that is how long you’re expected to hold your investments. In Lending Club, you do have the option of selling your notes sooner through the Trading platform, but you’ll be selling your investments at a discount. This is similar to how you have to pay an early withdrawal penalty when you purchase Certificates of Deposit.
One way to minimize your default risk is to invest in many different loans. For loans issued in the past five years (2015-2019), Lending Club default rate is about 1.61% for A-rated loans, 4.42% for B, and 8.29% for D.
This means if I invest in 100 B-rated loans, the chances are 4-5 of them will default, representing 4-5% loss. But if I am only investing 10 loans, there is a good chance that 1 out of the 10 loans will default and my loss would be 10%.
Principal Is Not Guaranteed
Due to the defaults, you can 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.
How to Minimize Risks When Investing in Peer-to-Peer Lending
Fortunately, there are ways to minimize the risks involved with peer-to-peer lending. Here are a few things that I look for in my borrowers:
- Good credit rating – invest in mostly A-rated and B-rated loans, and only a few C-rated loans.
- Low debt-to-income ratio (DTI) – start by investing in the lowest DTI loans first and move up if you still have more money to invest.
- Low credit inquiries – this avoid borrowers that try to take out many loans from different lenders
- No delinquencies – this indicates the borrower is most likely not a deadbeat.
- Smaller loan amount – this ensures that the borrower is not in deep distress for money.
Additionally, here are a few more tips:
- Diversify your portfolio by lending only $25 to many borrowers, as opposed to lending a large amount in a few loans.
- 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.
How to Start Investing in Peer-to-Peer Lending Networks
To start lending with Lending Club:
- Go to Lending Club web site
- Click on the Start Investing Today button
- Complete the application
- Click on the confirm link in the registration email, and login
- Click on the Invest button
- Complete your profile to verify your identity and link your bank account to Lending Club
- Once verified, click on the Add Funds button from the Account tab, and transfer at least $25 to your Lending Club account
- From the Summary tab, click on Browse Loans to start lending money by picking individual loans to invest in.
For a first time lender, I suggest using the Automated Investing Tool
- From the Summary tab, click on Automated Investing
- Click on Start now
- Click on All Grades
- Click on Save Strategy
The system will begin to invest and reinvest the money for you automatically. You can also use the Build a Portfolio Tool, which is the middle ground between the two options above. You can access this option by clicking Invest > Manual Investing > Order Builder. Pick the desired filters and then choose between the three options.
Like any investment, investing in peer-to-peer lending has its risks. You should evaluate these risks carefully before investing in these platforms. From my personal experience, the risk-reward characteristics feel about the same as investing in high-yield bonds. I experienced about 5% annualized return over the past ten years and feel this is a legitimate investment option for those who want to diversify beyond the Stock Market. That said, I would not invest more than 5% of my total portfolio in peer-t0-peer lending, and I would invest mostly in higher grades loans.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.