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).
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.
Pinyo 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®.