I’m a young investor and want your thoughts on peer-to-peer lending. Sites like LendingClub.com are pretty open about returns, default rates, etc. Based on the past three years, this has been a pretty reliable way to get an approximately 10% compound return. I realize that peer-to-peer lending doesn’t have the 70-year history of stocks and bonds, but what do you think about making it a small part of my portfolio?
Over the last several years, peer-to-peer lending (P2P) has been growing in popularity. One P2P Web site, Prosper.com, has nearly a million members. Popularity does not necessarily mean an investment is worthy of your consideration.
P2P is an alternative means for individuals to borrow and lend directly from and to each other, supposedly cutting out financial intermediaries such as banks. The activity is arranged through Web sites as Prosper.com and LendingClub.com. The sites typically charge loan servicing fees averaging 1% annually.
So what’s not to like?
For starters, think about the concept of adverse selection. In the insurance industry, this principle holds that if people are given the choice to buy insurance or not to buy, only people who really need coverage (and therefore those who represent bigger risks) will buy it. In the world of lending, borrowers with excellent credit are likely to rely on conventional sources, while those with poor credit are drawn to alternatives such as P2P.
What this means to you is that you will be lending money to people who may not qualify at banks, credit unions or credit-card companies. This means you, as a lender, are taking a higher risk and will expect a higher return. The 10% figure that’s been quoted on the Internet should be an important clue.
Consider that interest rates are so low that established, legitimate businesses can only dream of getting 4% on their savings with a bank. If those businesses thought they had a good chance of being paid back while collecting anything close to 10%, so much money would rush into P2P that individuals like you might be shut out.
The high rate of return quoted is a strong indication the money is going to a pool of relatively risky borrowers who can’t get loans without offering extraordinarily high interest. This is the basic risk-reward principle at work. Higher risk is associated with higher potential returns.
In the United States, P2P loans are unsecured, and information about the borrowers is relatively limited. Various Internet sites report that default rates on such loans range from 15% to 20%.
For all these reasons, I would advise against P2P loans. I can see the temptation, but the fundamental truths of investing have not been repealed. If something seems too good to be true, it probably is.
If, as a young investor, you should want to take smart risks in order to make your savings grow over time. The most reliable way to do that is by investing in the equity markets through mutual funds. Their long history, the large amount of available information and oversight of government regulatory agencies are all on your side. You will not have any of those allies in P2P lending.