Peer2Peer Lending: How Risky is it in Bad Economic Times?

Many people are looking for creative ways to invest their money, because interest rates on savings are, essentially, zero.  I used to jokingly say that soon, banks would charge US for keeping our money.  But I’m no longer joking!  With the increase in service fees that I have observed in the past few years, that is exactly what is happening!

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Many investors, tired of essentially giving their money away to the banks, have turned to more profitable – and risky – measures.  Peer to Peer lending (or Peer2Peer Lending, as it is commonly known), is one of the more profitable of these measures.  Peer2Peer Lending is a system by which willing lenders and borrowers meet in a central marketplace to lend and borrow, as it were, to the mutual advantage of each.

The two main venues for P2P lending in the United States are Prosper and Lending Club.  They have many similarities, but the details of their operations differ in several ways.  I am most familiar with Lending Club, so my comments will pertain mostly to that venue.  In Lending Club, borrowers fill out a loan application and go through several levels of vetting.  According to what I am told, only about 10% of the borrowers are allowed to continue on to the actual loan process.  Their prospective loans are rated according to credit rating, years of employment, length of the loan, and several other variables.  The loans are then anonymized as to name and other identifying details and placed on the market for investors to discover and invest.

The investors, by that point, have funded their accounts with transferred funds from their banks, and they choose the level of risk they wish to entertain.  Based on their choices, the lenders can either choose loans in which to invest or have the loans chosen for them automatically by Lending Club.  They then can fund the loans in any amount from $25.00 at a minimum up to the entire amount  available in their account for investment. Once the loan is fully funded, the borrower receives the cash and begins making payments to Lending Club.  Lending Club then takes a 1% fee for itself, divides the payments into principal and interest, and distributes the rest of the payment amongst the lenders who have invested in that loan.

This all sounds very wonderful, doesn’t it?  Interest rates range from a low of some 6% to upward of 22%, depending on the risk profile of each loan.  When was the last time you earned some 10%  or more on your investment?  Heck, when was the last time you even earned 6%?  For me, it’s been a long, long time.

There are a few problems though, which I have known about for some time, and they all involve risk of default.  There is a general historical default rate which is disclosed by each lending platform, but a post at Nickel Steamroller Blog opened up a somewhat concerning possibility (and this is why I am posting this in a prepper blog, not my finance blog – though I’ll probably post it there, too!)  While most investors understand that there will be some defaults on these loans – they are, after all, risky – what would happen if things got so bad that a huge number of people defaulted due to economic conditions?  Those who chose the highest rate and by definition riskiest loans, will be in a world of hurt!

During the height of the financial turmoil that occurred in 2008 A grade loans performed the best, producing ~+4.0% returns. F grade loans which are currently the best returning loans, returned (-3.85)% annualized for those issued in 2008.

This type of loss is not something we want as investors! Of course, higher reward means higher risk, but keeping in mind that this is not a liquid investment, and these unsecured loans are the first to be abandoned by the borrower, a keen eye on the economic situation is in order.

So, here’s my warning:  if you choose to use Lending Club or Prosper as an investment platform, be aware that it’s absolutely essential to hedge your risk (just as you would with any investment) by taking two important steps:

  • be sure to include some of the lower-risk A and B-grade loans in your portfolio, and
  • remember that this is only one platform. Diversify your risk by diversifying your investments!

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4 Responses to Peer2Peer Lending: How Risky is it in Bad Economic Times?

  1. Peter Renton says:

    While it is true that the higher grade loans like Grade F will be hardest hit in another recession I expect they will perform far better than those that issued in 2008. Why? Because underwriting is more strict today and they have a full 5+ years of loan history. I expect even in a deep recession like 2008-09 investors will see positive returns across even the higher loan grades like Grade F. But let’s hope we never find out.

    • Georgene says:

      Nice to see you here, Peter! Wow, you get around! Folks, Peter is the number one source of info on the peer-to-peer lending platforms! I’m honored to have him here. Give his site a visit!

    • Dan B says:

      Well though I agree that returns should be substantially better in the next downturn, the reality is that we will find out, sooner or later. Right now the only thing in contention is when that’ll be.

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