You may be familiar with peer-to-peer lending — either as a borrower or lender. If not, I’ll explain.
Traditionally, consumer loans are provided by banks and other financial institutions. Recently, these loans have been offered through internet-based platforms in which the lenders are other individual investors. These networks are the banking equivalent of AirBnB but instead of matching renters with homeowners, they match borrowers with lenders. The platform is an intermediary that processes applications, checks credit, collects payments, etc.
The two best known services are Lending Club and Prosper.
If you’re a borrower, you choose a 3- or 5-year fixed rate loan; if approved, your interest rate is based on your creditworthiness. Borrowers often use these platforms to refinance existing debts into a fixed rate consolidated loan with a lower interest rate.
If you’re a lender, you can specify both the term of the loans you seek and the creditworthiness of the borrower. Riskier borrowers offer higher interest rates but, no surprise, they default at higher rates. The loans are broken into small pieces and you typically invest in a small portion of many loans.
As a lender, peer-to-peer lending offers two diversification benefits for your investment portfolio:
- Consumer loans are a different asset class. These loans have different risk/return characteristics from stocks and bonds and thus can offer additional diversification across your entire investment portfolio.
- There is little default risk from a single borrower. Instead of funding a borrower’s entire loan, you fund small pieces of many loans (as small as $25 per loan). In this way, you have little risk exposure to any single borrower.
Do they make sense for either borrowers or lenders?
If you’re a borrower, these platforms can be a good option. Taking out a consumer loan is a commodity service in which the interest rate is the primary consideration. If you can obtain a lower rate through these platforms, there is little reason not to do so.
If you’re a lender, they have not been a great investment opportunity. For better or worse, I speak from experience as I’ve been a lender in the Lending Club platform for the past four years. Why has it not been a good investment?
- Your funds are illiquid. It is not easy to access your money before the loan has been repaid. Yes, there is a secondary market in which you can conceivably sell your portfolio of loans but it is not a well-functioning market and you will sell them at a loss.
- The returns have been mediocre. Because of how future loan defaults are estimated, it is difficult to exactly measure the returns at any moment, but over a 4-year investing horizon, my returns have averaged between -2% and 5%. By comparison, bond mutual funds offered similar returns over this period but with immediate liquidity.
- The tax treatment is poor. For non-retirement accounts, you’ll generate lots of interest income, rather than tax-favored capital gains or qualifying dividends. I invested retirement funds to avoid this issue and if you’re still tempted to become a lender, I’d recommend you do the same.
P2P lending has been beneficial for borrowers but not for lenders. As a borrower, compare these rates with what you can receive elsewhere and consider using one of these platforms if you are able to receive a lower interest rate; as a lender, I’d stay away unless the returns improve.
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