Beating Broke

Personal Finance from the Broke Perspective

Yes, Peer-to-Peer Lending is Risky, But Not Cursed

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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.

You Are Not Losing Money In Your 401(k)!

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I was watching my local news when they did a spot on people who were vacationing a little closer to home this holiday season because of the economy or other reasons when one of the people who they interviewed blamed their need for staying closer to having lost money in her 401(k).  Besides the fact that that money is, for all intents and purposes, off limits until you retire, and really has no effect on your current financial standing, how do you lose money in your 401(k)?

Did it get misplaced?

I’m being a bit facetious here to prove a point.  To lose money implies that the money is no longer yours.  Except that the majority of your “money” in a 401(k) isn’t actually money.  It’s shares of companies or mutual funds or index funds or ETFs.  You aren’t losing money.  You’re losing value.  The securities that you purchased with your money are not as valuable as they were when you bought them.  You still own the same amount of securities, which you converted your money to, so you still have all of your money.  It’s the value that you’ve lost.

Better example.  You buy a car for $10,000.  After driving the car for 5 years, you sell it for $5000.  Did you lose $5000 on the car?  Not really.  Very few people will think of it that way.  Because most people do not assume that they will gain value in a car, so they accept that they will not be able to sell the car for the same amount they bought it for.  And it is almost guaranteed that it won’t gain any value.  Again, though, you lost value, not money.

Losing value isn’t as bad as losing money. Why? Because, unless you need to realize that value immediately, you have time to wait and see if the value does go up.  And with securities, chances are that they will.  And in a locked up instrument like a 401(k) with all it’s penalties to discourage realizing that value until retirement, many of us have decades to wait and see how things turn out.  And, if I were a betting man (which I am sometimes), I would put pretty good odds on my 401(K) gaining value between now and when I need to withdraw any of it.

Note: I don’t encourage waiting to see if the value of your car will go up.  Unless you plan on waiting decades for that also in hopes that it will become a classic collectable.

Mark Cuban Lays it Out

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If you’ve been reading Mark Cuban’s blog lately, you’ve likely noticed that he’s been talking alot about the current economic situation and also about how a person should handle his/her money.

Today is no different.  In a post entitled “Where to Put your Money Right Now“, Mr. Cuban gives some advice in a manner that only he can.

So in a nutshell, while the interest rate on your credit cards is going up, the return on your investments has been going down. You know what they call someone who keeps on giving money to their stockbroker, mutual fund or 401k, but doesn’t pay off their credit card balance in full every month, BROKE AND STUPID !

The first thing you do with your money is if you have money market funds, you take the money out and pay down your credit card debt.

A little brutal and not even close to politically correct.  I love it!  I think it’s statements like this that have drawn me to people like Mr. Cuban and Dave Ramsey.  They aren’t afraid to tell you when you’ve made a complete buffoon of yourself.

I would strongly encourage you to read the rest of Cuban’s article.  It’s a little long, but it is most certainly not short on good advice and sound instruction.