How To Avoid The 3 Biggest Risks In Peer Lending

If you haven’t heard about the peer lending revolution yet, you soon will. Both companies in the space, Prosper and Lending Club, are issuing more than $100 million in new loans every month.

The revolution in peer lending is opening a new world to investors but many are being caught off guard. Know the risks and resources before investing in online loans and you might just find one of your favorite investments.

Peer lending is taking the power from big banks

The first peer loans were made on Prosper nearly a decade ago but the movement has only just begun to gain momentum over the last year. It took Prosper over eight years to originate a billion dollars in loans. It took the loan platform just six months this year to originate its second billion.

Peer lending is the coming together of the online world and traditional lending. Borrowers fill out an application for up to $35,000 on a lending website, either Prosper or Lending Club in the United States. After a credit check and review, the application is assigned a credit rating and an interest rate.

The loan request then goes live on the website for investors to fund. Investors decide how much they want to fund in a particular loan, as low as $25, and in how many loans they want to invest. Once enough people choose to invest in a loan and it reaches its requested amount, the money is deposited in the borrower’s bank account.

The borrower makes regular payments to the lending website, as with any loan, and the website passes payments on to investors. The concept is nothing new, people have been investing in bank loans for ages but they’ve always had to go through the bank or a brokerage firm.

Peer lending is changing all that and connecting borrowers with investors directly.

Too much risk or just the right return?

High-yielding investments could not come at a better time for savers. Rates on government bonds pay next to nothing after inflation and you’re lucky to get the stock market’s 7% annual average, if you can avoid the next major crash.

The table below, constructed from data on peer loans through Prosper, shows the loss rate and return across the website’s seven risk ratings. Averages across the categories and across all loans are quite good, especially compared to other types of investments.

But that doesn’t mean investing in peer loans is without risk. Of those I have interviewed and from my own personal experience, three common mistakes seem to plague new investors in peer lending.

Investor risk #1: Double-digit returns? Sign me up!

Probably the most common mistake is that new investors see the potential for returns approaching 30% in the most risky loans and leap into the category before they understand the danger. Dreams of sandy beaches and Mai Tai cocktails quickly turn to angst when loans in their portfolio start defaulting.

There is a reason why those loans are in the high-risk category! These are borrowers with missed payments or worse and the possibility for default is high. One look at the table above should prepare you for defaults on one-sixth the loans in the HR category.

You absolutely must understand your own tolerance for risk before investing in peer loans. If you get skittish at the first sight of losses, then you’re probably better off investing exclusively in the safest categories. While there will be an occasional default in these as well, the frequency is much lower. If you can ride out a few bad loans and look at the bigger picture without stressing out, there is no reason you would not be completely comfortable investing in higher-risk loans. Notice that even after higher defaults in the HR category, the average return is still very high compared to the safest categories.

Investor risk #2: Diversification is just for stock investors, right?

Many jump into peer lending and ‘test the waters’ with a few loans before they really give the investment a chance. Investing in less than 30 loans is not investing at all but gambling.

If you want to gamble with your savings, Las Vegas is a whole lot more fun.

I understand the idea that investors want to play it safe and not commit too much money to peer loans before they understand what can happen. Even investing the minimum of $25 each across 20 loans translates to a $500 commitment. The problem is, if even one of those borrowers defaults, you are already down 5% from where you started.

Unless you have a crystal ball into the realm of credit and loan defaults, you need to spread your investment across enough peer loans that a small number of defaults will not completely wreck your return. I normally recommend investing in at least 50 loans so that each only accounts for roughly 2% of your total portfolio.

Investor risk #3: The Dartboard Strategy

This is really the extreme opposite of the previous risk and probably my biggest pet peeve of advice in peer loans. You will find websites that recommend investing across hundreds or even thousands of loans. You could not possibly analyze the criteria in more than a few hundred loans so this strategy is basically just investing across all loans in a category or across the site. While this kind of index-investing strategy is popular with stocks, you risk leaving a lot of money on the table by using a dartboard approach.

There are factors that can be used to pick loans that can produce higher returns than the average across the platforms. I recently interviewed one investor that turned early losses to an five-year annualized return of 14% and a gain of $9,000 by changing his strategy for picking loans.

Don’t get me wrong, you absolutely need to diversify your portfolio across many loans. Putting all your money into a few loans risks chaos if just one loan defaults. Contrary to what some would say, you can achieve all the diversification you need with about 100 loans. While diversified, this still gives you the opportunity to pick loans based on criteria that can lead to higher returns.

As great as the potential is for investors, peer lending is opening new opportunities for borrowers as well. More than three-quarters of peer loans are being used to consolidate high-rate loans and help dig people out of a vicious cycle of debt. The revolutionary idea is not without its risks for borrowers as well. Fortunately, blogs like peerloansonline.com exist to educate borrowers and investors to make your experience in the world of peer lending a success.

Author: Joseph Hogue, CFA. PeerFinance101 is all about sharing our stories of personal finance challenges and success so we can learn and meet goals together. Share anything from living with debt, investing, peer lending or any other personal finance topic.

Are you interested in peer lending? Why or why not? How are you investing your money?