In June of 2008, SMI ran an article on peer-to-peer (P2P) lending, describing a process whereby individual borrowers and lenders could each get a better deal by cutting out the middle-man (i.e., the bank). It was a new — even revolutionary — concept, something only a maturing Internet could make possible. Three years later, the idea has advanced and many of the regulatory and risk questions have been answered.
Today, the largest P2P lending site is LendingClub.com, which coordinates more than $20 million in loans each month. Prospective borrowers detail why and how much they would like to borrow. LendingClub assesses the borrower's credit-worthiness and places each request in an associated loan category based on risk (on a scale from A to G). Lenders (i.e., savers/investors) then offer to fund the loan (with as little as $25). If not enough lenders are willing to buy in, the loan is cancelled and nothing happens. If you offer to participate and the loan does get fully funded, money is transferred from your Lending Club account to the borrower's.
Usually, loans are funded by pooling money from many individual lenders. A $5,000 loan, for example, might be funded by 200 different people each putting up $25. Many lenders have portfolios that consist of hundreds of such "microloans," which helps diversify their portfolio and reduce risk.
To help lenders make informed lending decisions, Lending Club posts borrower profiles that include a credit rating range, debt-to-income ratio, and information about any current and past delinquencies. Lenders can either create their own criteria to find loans that are acceptable (recommended) or let the Lending Club system do it for them (faster, but higher risk).
In the current low interest-rate environment, the potential of building a micro-loan portfolio that yields 7%-9% (which includes a cushion for a handful of potential defaults) is appealing. This type of yield is possible even when still targeting the lower end of the credit-risk curve. The lender gets higher yields than traditional sources are offering. The borrower gets a better interest rate than they would qualify for from traditional lending sources. It's win-win.
In addition to default risk, however, it's important to note that most P2P loans have a minimum three-year term — with no early-call provision (though there is a growing secondary market for selling and buying loans). So, if liquidity is an issue, P2P probably isn't for you. This means you shouldn't use P2P lending services for your emergency fund money. But if liquidity isn't an issue, P2P lending could be a good option for an accumulation fund.
I have been using Lending Club for nearly a year now and my experience has been very positive (no issues or defaults). A few personal observations:
• If moving money electronically from your bank account to another account concerns you, this is not for you. Paypal users will feel at home.
• Set up is straight forward. Create an account, set up an "Automated Clearing House" (ACH) link to your bank account (it takes one-to-two days to do this), then transfer money from your bank to Lending Club for use in making loans (i.e., investing in "notes"). It takes three-to-five days to do a transfer.
• Notes are sold in $25 increments and vary in their purpose, interest rate, term and credit-worthiness of the borrower. The notes are tied to loans of either three- or five-year terms. Longer terms pay higher interest, but have higher risk of default and inflation/interest rate risk. (For now, I only buy three-year notes).
• Lending Club recommends owning a minimum of 100 notes in order to diversify default risk. At $25 per note, that means a $2,500 minimum. You can start with less than that, but should plan on building toward that level fairly quickly.
• Lending Club has great tools to help recommend notes based on purpose, interest rate, term, credit worthiness, late payment history, and more. I stick to debt consolidation and credit card payoff loans, since these should result in lowering the debt servicing cost of the borrower and improve their cash flow. Home improvement, business start-up, and similar loan purposes are a bit too risky for my blood, at least for now.
• Once you invest in a note, it does not begin accruing interest until the loan is issued. This can take a week or more as other investors buy enough notes to issue the loan. Sometimes loans don't get enough investors and money you have committed to a loan is released back to you to invest in other notes. This has happened with roughly 10-20% of the money I've invested.
• Accrued interest and a return of principal is paid to you monthly. Once this reaches $25, you can reinvest in more notes.
• Lending Club presents an expected rate of return for a given set of notes, based upon the expected default rate and after accounting for their fees. Your results will vary, because you may have more or fewer defaults (again, diversify!)
I've found LendingClub to be a solid alternative at a time when good yields are difficult to find. I like that I'm helping people reduce their debt faster by providing lower interest rates than they could otherwise obtain. So far, I've been fortunate to avoid any bad loans. But my loan portfolio is conservative enough that even if I have a few, those defaults shouldn't put a huge dent in my returns. If you limit yourself to practices that limit risk (short loan maturities, small amounts, wide diversification, debt-payoff purposes, lending only to people with higher credit ratings, using aggressive search criteria to weed out bad loans), P2P lending appears to be a reasonable option for those in search of higher yields for their accumulation fund money.