How to Invest in Consumer Debt via Peer-to-Peer Lending

Many investors are familiar with investing in corporate and government debt through the purchase of bonds. Bonds are often attractive because they’re considered one of the safer types of investments. This is especially true of U.S. Treasury bonds which are guaranteed by the U.S. government. Did you know that you can also invest in consumer debt?

The big banks make billions of dollars in the interest and fees from consumer borrowing. As of November 2011, consumers hold $2.5 trillion in debt and they’re paying interest on that debt month after month. The debt would be even higher, except there are some consumers who can’t or won’t borrow from big banks, either because they don’t meet the bank’s qualifications or possibly because they don’t like banks. Therein lies the opportunity for you to capitalize on consumer borrowing.

Investing in Peer-to-Peer Lending

Peer-to-peer lending isn’t a new concept. People have been loaning money to each other for centuries. But, sites like Prosper.com and LendingClub.com have made it easier for borrowers to find loans and for people like you and me to fund these loans.

Investing in consumer debt chart

As with a bank loan, borrowers go through a qualification process to get a peer-to-peer loan.

With Prosper, borrowers are given a rating, AA, A, B, C, D, E, or HR, which indicates their default risk. Loan rates are assigned based on the borrower’s rating. A rating of AA is the best carries the lowest interest rate, while HR is the worst rating, indicating a high risk and currently carries the highest interest rate.

Lending Club, another major player in the Peer-to-Peer (or P2P) lending space, has a similar rating system with ratings from A through G, where A is best and G is worst. Lending Club boasts an average borrower FICO score of 715 (which is very close to excellent) and almost $70,000 personal income.

How Investors Make Money By Lending

When you lend money through a P2P network, borrowers pay you back, with interest of course. You can choose loans individually by scrolling through each borrower looking for a loan, or you can allow the network to invest for you after selecting your investment criteria. The P2P network takes a small cut of the interest and you keep the rest. The lending risk is spread among many different lenders, so you don’t have to take on the risk of a $20,000 loan unless you want to.

From a lender perspective, higher interest rates mean higher returns. However, borrowers with higher rates also have a higher risk of default. You can lessen the impact of a default by spreading your investment among several different loans. Instead of investing $100 in 10 different loans, you can invest $25 in 40 different loans. That way, if one borrower defaults, you’ve only lost $25 instead of $100.

You may not be able to pursue a borrower who defaults on a loan. And there’s double the risk of not getting paid – both from borrower default and P2P network failure. The former is much more likely than the latter.

Returns seem to be attractive, with several blogs and media outlets reporting an average 10% return. According to Daily Finance, Curtis Arnold of CardRatings.com earns 11% to 13% on his P2P loans. Another lender, Greg Collett says his returns are around 14%. Of course, these rates aren’t guaranteed. Don’t immediately lend out your entire retirement savings. Instead, start small. Get familiar with the lending system and then work your way up to a larger investment after you’ve found what works for you.

Picture by FreeDigitalPhotos.net.

About the Author

By , on Jul 28, 2013
Eliza Collins is a personal finance writer specializing in savings strategies, alternative income and debt relief options. You can read more of her articles at the debtsettlement.com blog.

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{16 Comments}

  1. I’ve stayed away from peer to peer. I know the returns look ok, from what I understand you get taxes as ordinary income – interest income – and not long term capital gains, because of the nature of the transactions. But I know several people who love it and it does provide alternative sources of financing for people who need money.

    Nick

  2. Nice post.

    Prosper and Lending Club sound like interesting options.

  3. know more says:

    it easier for borrowers to find loans and for people like you and me to fund these loans.

  4. I’ve used both lending club and prosper. I’ve had better results on lending club and I like their interface more. There was another company I wanted to check out, but their name escapes me right now.

    Thanks,
    Timothy

  5. Eliza says:

    It is a great way to diversify and earn good returns, but remember that if you don’t spread your money into enough loans, one default can have a very bad effect on your overall return. It doesn’t happen very often, but there are defaults in these networks every now and then.

  6. Brad says:

    I have 57 loans with Lending Club, all at $25.00 each. I love it and buy a new loan each week. I stay with the rated A and B loans. It is kind of fun to buy the loans each week! My average return right now is about 7.88

  7. While this is an interesting concept I’d have to do a lot of research before investing in anything like this. I seem to remember a website called my rich uncle that did private student loans that went out of business and I wonder what would happen if lending club or propser did the same thing…

  8. I’ve been toying with the idea for a while, but I’m not 100% comfortable with it just yet…

  9. Michelle says:

    Thanks for the thorough, informative breakdown! Makes it sound like a no-brainer.

  10. I may actually do this instead of individual stock investing – the risks and returns seem more favorable. I like the iea of being able to help regular people by sidestepping traditional banks.

  11. In my state, Lending Club is not allowed, and Prosper needs a net worth of $70K. Appealing, but not for me right now.

  12. Great summary. I was looking into LendingClub last year but after reading a lot of personal experiences it seems as though you have to spread your money across a wide spectrum of people. They stressed that you should diversify your options just as you would diversify your portfolio for stocks. Also, a lot of people were stating that sometimes the ones that you wouldn’t think would default (with high ratings and lower interest rates) were sometimes the ones that defaulted. Just some additional thoughts to add.

    I don’t think I’m comfortable with P2P lending yet but it is definitely another great option to diversify.

  13. I have been reading a lot about P2P lending and it’s something I am seriously starting to consider. Another great way to diversify.

  14. Modest Money says:

    I’m really interested in P2P lending. It just seems like a great idea to help people out without them having to deal with the big banks. Plus the returns sound pretty attractive. Once I have some extra cash flow I will have to see what options are available for Canadians.

  15. This is a great introduction to P2P lending. There are some states that restrict individuals from participating directly in P2P (Texas is one), but you can purchase the notes of others who have loaned via P2P networks (I am not sure I am explaining that correctly, but the core concepts are correct).

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