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Is Peer-to-Peer Lending Too Risky?

Posted In:  mortgage

Peer-to-peer lending has shown itself to be a smart debt management technique in a time when credit is hard to come by. Credit card companies are raising rates and dropping consumer rewards, and the relatively inexpensive rates charged by social lenders can save consumers a bundle. Borrowers can consolidate high interest loans into one lower interest loan and take up to three years to pay back the debt. The sheer brilliance of this scheme, so well timed in this economy, got me to thinking about social lending as an investment. Is peer-to-peer lending a good investment?

First of all, if you are in a social loan right now, it’s not the right time to start investing in it. Pay off your loan, avoid new debt and then look at social lending after your debts are paid off. The investment is unlikely to pay more than you could save by paying off your loans and pocketing the saved interest. But if you have the extra money, social lending may just be a better bet than stock markets or even real estate.

What is Peer-to-Peer Lending?

Peer-to-peer lending is a relatively new way of borrowing or lending money without the help of financial intermediaries or banks. Also known as "social lending," peer-to-peer lending offers both pros and cons to those looking for a good investment.

Social lending is facilitated by a variety of websites. At the forefront of this niche are the sites Prosper.com and Lendingclub.com.  Prosper has facilitated more than 32,000 loans to date, valued in excess of $194 million. LendingClub recently announcing that it facilitates four times as many loans as Prosper.com.

You may recall the mention of virgin money previously. While the site does facilitate peer-to-peer lending, it’s geared towards those who already know who they will be lending to. Other sites match the investor with the borrower, sort of like a monetary dating service. 

SEC Oversight

Prosper and LendingClub have each had a share of troubled times. When these enterprises were first launched in 2006, there were no clear rules about financial oversight. In 2008, LendingClub saw the writing on the wall and shut down for six months to secure SEC registration. Prosper stayed in business to reap the rewards of picking up the spare business. This strategy proved to be fateful, however, when the SEC shut down Prosper’s operations, forcing them to register.  The SEC asserted that the company was selling investment vehicles and was therefore subject to SEC rules.

At the time, Prosper had the lion’s share of the peer-to-peer market. But the SEC action kept Prosper out of the game about three months longer than LendingClub. The adversary took advantage by gathering up market share in the interim. By closing voluntarily ahead of Prosper, LendingClub was able to recover more quickly and set a precedent that affirmed the SEC’s stance.  This smart and clear-headed strategy allowed the company to gain a strong advantage in the marketplace as evidenced by the volume of loans it can facilitate compared to Prosper.

New Investment Capital Arrives as the SEC Bows Out

Both companies are doing well now. Prosper.com recently gained 14.7 in funding from TomorrowVentures and others, making its current total funding $57.7 million. For those not strongly versed in Googlese, TomorrowVentures is Google CEO Eric Schmidt’s investment vehicle.  Lending Club, is also raking in the funding, now having raised a total of $24.5 million...not exactly chump change.

The renewed interest in peer-to-peer lending may be a side effect of the December 2009 bill, H.R. 4173, the Wall Street Reform and Consumer Protection Act. The bill formed a new group, the Consumer Financial Protection Agency, and put the regulation of social lending under the agency’s oversight, rather than the SEC. Prosper’s CEO Chris Larsen, thinks that makes sense, noting that the SEC was made to oversee investors, not borrowers.

But is it a Good Investment?

All that venture capital can make you want to jump on the peer-to-peer bandwagon quickly, but stop for a moment and look deeper. Are people paying back those loans? Well… yes, many are. Since the SEC’s involvement in social lending, Prosper says their default rate has gone from 29.3% to 0%.  We suspect there's more than a bit of exaggeration there, but there's certainly evidence of improvement.

Of course, one must give these loans time to mature. Prosper only resumed business in July 2009, less than a year ago. Whether these loans continue to be successful remains to be seen.  To be prudent, one must compare peer-to-peer lending against other major investment vehicles such as stocks and real estate, both of which have seen their share of hard knocks lately.

Risk Assessment

The most obvious and attractive aspect of social lending for investors is the ability to filter through requested loans and choose their level of risk. Investors have greater access to information than with stocks as well, being able to ask borrowers directly about their financial situation. Try getting hold of a CEO for a question and answer session and see where that gets you as a small investor. 

You can still analyze stocks to determine your level of risk, but such investments are much more complicated and risky. Just look at Toyota, a company that looked like a great investment until just a few months ago. The news can turn an earner into a flop very quickly. In real estate, the risk of a particular investment is typically easy to evaluate, but may be less dependable in the current economic climate.

Initial Investment

It is easy to invest in social lending. One can choose the quality of borrower, look at the borrower’s credit history, and even ask the borrower questions before making a decision. It’s only a matter of a quick funds transfer and 1% of the proceeds go to the facilitator. Investing in stocks is similarly easy, once you get over the hurdle of risk assessment. Starting a real estate investment is much more difficult and expensive. It requires a large down payment, attorneys’ fees and other legal requirements.

Tax Advantages

Social lending revenue is taxed as ordinary income, putting it at a decided disadvantage. Stock investors pay capital gains tax, which can be stretched out over time. Real estate investors have the greatest advantages when it comes to taxes. Individual homeowners can deduct loan interest, real estate taxes and energy saving improvements, among others. Those who invest in additional locations as rental properties can deduct many of the expenses associated with running and maintaining the property, along with depreciation. Many rental property owners realize a substantial tax-free profit this way.

Cost of Investing

SavingTools is all about saving you money, so it wouldn’t be right to skip talking about the direct fees associated with each type of investment. Dollar for dollar, social lending is less expensive for small investors. LendingClub charges a 1% fee, while stock investments trade for a flat fee. Larger investors will find stock investing cheaper. Real estate is by far the most expensive type of investment to start when you consider closing costs. 


Average return, source: prosper.com

Readers: See lendstats.com for an independent
source of ROI information on Prosper.

Risk Versus Reward

The level of reward investors gain on each type of investment can vary greatly, depending on the grade of loan, type of stock or property chosen. Just as with any investment, greater risk can result in greater reward or greater loss. Comparing rates of return is impossible because each of these vehicles carries different time scales. In the housing and stock markets, these rates have fluctuated wildly in recent years. Add to that the fact that peer-to-peer lending is a fledgling industry. The average rate of return cannot be considered a “historical” rate because the industry has little history to go by.

Compared to other traditional sources of investment stocks such as real estate or the stock market, peer-to-peer lender claim a yearly return on investment between 8 and 10 percent. Comparatively, the stock market averaged about 6% gain per year in the latter half of the decade, according to Brookings.com. Real estate returns have been historically 2 to 4 percent when adjusted for inflation and the cost of borrowing to purchase a home.  If the claims are indeed true, this appears to be the draw for social lending.   Reward, of course, implies risk.

 

Looking at the best predictions available to us from economists, we see an even better picture for social lending. USA Today reports that returns from the stock market are expected between 6 and 8 percent. The housing market is expected to remain flat through this year and probably for another two years. At the same time, peer-to-peer lending shows no signs of shrinking. Returns should be even higher if interest rates are raised to combat inflationary pressures as the economy begins to recover. So even by the current actual return of 8 to 10 percent, social lending is beating out the big boys.
 

How Risky is Social Lending?

While peer-to-peer investing is a young and growing industry with a positive outlook, a long-term view puts real estate as the safest balance of risk and reward. When the market does rebound, those who bought low in this market, should see a significant increase in value. Social lending still remains attractive because it's easy and almost anyone can do it. Investors with an interest in social lending should choose loans carefully for a greater chance of success. This depressed economy may be the perfect opportunity to profit from low interest rates and a high demand for loans. When investors choose borrowers wisely, peer-to-peer lending may prove to be more profitable than our old stock market and real estate standbys, but it carries a risk similar to, or slightly higher than, the stock market.

 

Jessica Bosari is an Internet copywriter and blogger for various publications and her own blog. You can read more of Jessica's work here.

Editor's note:  Some passages edited post-publication to reflect the potential high risk of investing in the social lending market.  SavingTools  advises you to consider that most high-return investments come with a high risk profile.  See lendstats.com for an independant analysis of risk and ROI in the Peer-to-Peer lending space.

 

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Re: Is Peer-to-Peer Lending Too Risky?

I've been investing in loans through the Lending Club for 2 years now.  The fun part comes from picking loans and deciding who to invest in.  I've done more than 400 loans and have experienced defaults (about 20) but even after those, I have made upwards of 8%... it's really amazing.  If you want to do it, just make sure you diversify though. I've heard stories of  pople who just put $500 in 4-5 loans, and if they were unlucky to pick one that does not pay, they lose money.