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Is Peer-to-Peer Lending Safe?

By: NerdWallet
Posted: 6/4/2014 1:06:00 PM
Referenced Stocks: GOOG;BLK

Peer-to-peer lending, or P2P lending, took off in the mid-2000s at a time when many borrowers were growing frustrated with mainstream financial institutions’ dominance of the loan process. Unlike more traditional lending practices, P2P lending provides the potential for greater returns for investors and lower interest rates for borrowers, both of which have helped make this alternate way of lending increasingly popular.

The success of Lending Club and Prosper, P2P lending platforms that pair up borrowers with investors, has also bolstered the growth of P2P lending. Lending Club started in 2007 and made loans worth $3.5 million in its first year. That figure has since grown to $3.4 billion. While this explosive growth suggests that many investors think P2P lending is a perfectly safe alternative to more traditional forms of investing, there are undeniable risks.

Unlike government-backed loans, for example, P2P loans are not insured. Moreover, Prosper faced serious legal issues in 2008, when the Securities and Exchange Commission issued a cease and desist order against the company, claiming it was selling unregistered securities. Just one year later, Prosper rebooted its business after securing SEC registration for its loans, something all P2P lending platforms are now required to do. Apart from a now-settled lawsuit stemming from a group of disgruntled investors, Prosper has since steered clear of any legal issues, and recently received an A+ rating from the Better Business Bureau.

While these new regulations have gone a long way towards addressing consumer concern about P2P lending, it’s still important to minimize the risks associated with this type of investing. Prudent steps include diversifying your investment mix.

How does it work?

Lending platforms like Lending Club and Prosper have quickly become popular and reliable ways of doing P2P lending. These websites simplify the process and do a lot of the work for you, like bookkeeping and transferring the funds in question, without charging as much as banks. After signing up with the website, borrowers essentially just select a loan amount (up to $35,000 if you’re using Lending Club) and describe where this money is going before posting a listing to the website.

Investors, meanwhile, sort through these listings and invest in whatever they think will fetch the biggest returns. Borrowers make monthly payments, which investors receive a portion of.

Because loans are uninsured, default can be especially painful for investors. For some, this risk is worth it, as returns can be substantial. Conservative, five-year U.S. Treasury notes usually yield 0.9%, while four-year corporate bonds can yield up to 7.33%. In comparison, a three-year loan rated B1 by Lending Club (on an A through G scale), can yield 10%.

Minimizing risk

P2P lending can be as safe as you make it. For those new to P2P lending, experts suggest starting conservatively and also diversifying your investments. In other words, don’t lend all your money to one borrower. Instead, hedge your bets by lending just a bit of money to many borrowers. This is the best way to protect yourself against one devastating default, according to most experts. You can opt to invest in only a portion of a borrower's request on Lending Club or Prosper. The straightforward logic behind this is that it’s unlikely that all of these borrowers would default on their loans.

Prosper claims that, since 2009, investors with 100 or more loans in their portfolio have never lost money. Moreover, rather than having P2P investments serve as the main source of your income, experts recommend that they constitute just a fraction of your larger investment portfolio.

Background checks serve as another security blanket: websites like Lending Club perform background checks on borrowers, which eliminate a lot of the mystery associated with lending money to someone you’ve never met before. You’ll know the credit score of whomever you are lending money to, along with other pertinent facts about their financial background.

Final thoughts

Thanks to the success of lending platforms like Lending Club and Prosper, similar websites are proliferating quickly , and thus continue to give borrowers and investors plenty of ways to conduct loans and investments. What’s more, several big players have given P2P lending a major endorsement. Just last year Google (GOOG) invested $125 million in Lending Club. A few months after that announcement, Prosper received a $25 million investment from Sequoia Capital and BlackRock (BLK).

A lot of money – and therefore trust – has been placed in the P2P lending model, which can be a great addition to your investment portfolio if you diversify your investments and practice the same good judgment you would when making any other important business decision.

Tony Armstrong is a staff writer at NerdWallet, a website devoted to helping consumers make smart financial decisions.