After my last two posts, and then this one, you must be beginning to think that this is P2P lending week here at Beating Broke. I hadn’t intended it to be this way, but it just seems like that is what’s on the brain and it’s getting a bit of buzz lately too.
Jim, from Bargaineering, wrote an article today about how risky peer-to-peer lending can be. I completely agree. But, he also made it sound like he thought that they should be avoided altogether. And that I disagree with.
P2P lending is risky. It’s just as risky as bank lending is for banks. And look at the mess they found themselves in not too long ago. But, as P2P lenders, we can learn a lesson from that. First, you shouldn’t be investing your nest egg in anything this risky. Once again, diversification is the key. On a scale of risk, P2P lending lands somewhere on the risky side of stocks. So, if you properly diversify, P2P should probably only make up about 2-5% of your portfolio. Also, the banks lent out way too much of their portfolios to way too many people that they really shouldn’t have. If you’re careful about who you lend to, you should be able to significantly reduce the risk. What that means is that you probably won’t be lending to to many people who will be paying 20% on their loans, and will be lending to more people who are paying in the 4-7% range. That’s OK.
Why any at all? Because the returns can be pretty good. Depending on the model you take, your return can be in the 5% range. The riskier loans you lend to, the higher the potential return. Some of them are in the 20% range. Of course, the caveat there is that those are also the most risky loans and the most likely to default. And, much like in the banking world, if a borrower defaults on a loan, you will lose money. You might manage to recover some of the money through collections, but it will only be a percent of what you lent out.
My advice? (not that it’s worth much) Be cautious. Don’t lend more than you can stand to lose, and keep the ratio of P2P investing pretty low in your diversified portfolio. Do your research. Lending to some 24 year old who is using the money to finance a class on real estate investing is probably not the best idea. Chances are, that loan is headed for default. On the other hand, lending to a mother/father of 3 who is going to use the money as a down payment on a house could be a safer loan. In the comments of Jim’s post, he mentions that he doesn’t invest in anything that he doesn’t understand. He doesn’t invest in options or futures because he doesn’t understand them either. That’s a very valid point, but I think it really boils down to how much information you want.
I think if Jim wanted to, he could find all the information he wanted to learn how to use option and futures investing. (note: I don’t understand them either and don’t invest in them.) P2P lending is a bit of a different cookie though. The bones of it are simple. One person is lending money to another person. In essence, as a lender, you are the bank. Using the available data, you review the loan applications and decide on which ones have the least risk of default. If you feel like taking on some riskier loans, you decide how risky and modify your acceptance practices to reflect. Is there more to it than that? Of course. But, if you keep your wits and only dabble a little while you’re learning the ropes, you can learn all of the intricacies from trial and error while not losing your shirt.
As with anything, there is risk involved. P2P lending has much more than most investing models. If you are adverse to risk, you really should probably avoid it. If not, get your feet wet. And per the usual disclaimer, seek the advice of a professional before making any major decisions.
Update: It seems the original story that spawned all of this (here at The Big Money) caused a bit of a stir at Prosper.com headquarters. They’re asking for a retraction and refuted the article with some of their own facts.