Scared off by stocks and real estate but seeking a higher return than a savings account? Consider testing social lending, where individuals loan money to other individuals and small businesses across America. The returns can be quite attractive — they currently average over 9% — and you may enjoy playing banker by selecting worthy borrowers from the comfort of your living room.
1 Year CD via
Rates, excluding fees, as of July 20, 2010. Propser returns based on ‘medium risk portfolio’.
While they are a bit more established in Europe, social lending sites (also known as peer-to-peer or P2P loan networks) burst onto the scene in the U.S. over the past two years, aiming to match individual borrowers and lenders. Lenders can start with as little as a $25 investment and earn rates that are far higher than those offered by certificates of deposit or savings accounts, even often exceeding those of riskier investments like stocks, bonds or mutual funds. At the same time, individuals turn to social lending to borrow money to grow their small business, consolidate debt or even to finance their wedding at a rate is lower than they can find from their bank. Social lending sites help match borrowers and lenders, providing important details on the borrower’s credit score and financial condition as well as their personal stories of what they need the money for and their ability to repay it.
If you are ready to dip your toe into this market, here’s our advice for getting started:
Start small. Both Lending Club and Prosper will let you commit as little as $25 to a loan, so start with just a few small investments to gain comfort with the process. Though the high interest rates (averaging over 9%) may sound irresistible right now, take some time to see how the process goes before you dive in with your entire intended investment. As the current banking crisis clearly shows, even the most highly trained and experienced credit analysts can back the wrong borrowers. You may also want to wait a few months to see several payments come in from your initial borrowers in order to gain confidence in making larger investments.
Ask questions. Make it a point to ask every borrower a question before committing to their loan, even if they’ve provided thorough detail. How they answer your question can be just as important as what they say. Are they prompt, professional and direct in replying to you? If they don’t communicate with you well now, don’t expect any better treatment if you encounter repayment problems later on.
Diversify. Reduce your risk by spreading your investment across various borrowers with different borrowing objectives, geographies, credit ratings and even loan networks. Lending Club’s portfolio of loans is currently performing well, but P2P loans carry a material risk of default, which means that you have the very real possibility of losing part or all of your investment. Diversification is the best strategy for minimizing this risk, ensuring that a bad decision will merely dent your return, and not cost you your entire investment.
Stick with higher quality borrowers. Lending Club provides extensive credit and financial data on each borrower, and helps your decision making by assigning each loan a risk rating grade, from A to G. There are currently zero A-rated loans in default, and just 3.1% of B-rated loans are in default*. Default Rates start to increase substantially with lower rated loans, so you can slash your risk yet still earn double-digit returns by sticking with Lending Club’s best-rated borrowers.
Average Interest Rate
6 – 16%
Minimum Investment Amount
Individual Notes or Portfolios
Rates, excluding fees, as of April 1, 2010
Remember, P2P loans should be considered to be high-risk, and you could lose your entire investment. As with any investment, be sure to perform your own, thorough due diligence.
Peter Renton is the chairman and co-founder of LendIt Fintech, the world’s first and largest digital media and events company focused on fintech. Peter has been writing about fintech since 2010 and he is the author and creator of the Fintech One-on-One Podcast, the first and longest-running fintech interview series. Peter has been interviewed by the Wall Street Journal, Bloomberg, The New York Times, CNBC, CNN, Fortune, NPR, Fox Business News, the Financial Times, and dozens of other publications.