This post is from staff writer Sierra Black. Sierra writes about frugality, sustainable living, and getting her kids to eat kale at Childwild.com.

Lately, I’ve heard a lot of buzz about how peer-to-peer (P2P) lending is a great alternative for investors who feel burned by the stock market. Proponents of peer-to-peer lending say it’s a smart way to get a good return on your money without the risk of a failing economy. But before you pull up stakes in your index funds and hightail it for the nearest P2P lending site, let’s take a closer look at the pros and cons.

Note: Over the weekend, Trent at The Simple Dollar also offered his thoughts on peer-to-peer lending.

A Brief Intro to Peer-to-Peer Lending
In its oldest, simplest form, peer-to-peer lending is what happens when you loan your mom money to start her new hairdressing business, or borrow funds from a friend for a down payment on your new truck. You’re making or taking the loan based on your relationship with the person, which counts for more than their credit rating or collateral.

Sometimes loans to friends and family work out well, but often they don’t. They’ve funded many dreams, but they’re also famous for breaking apart families and friendships that have stood the test of decades. An old saying goes, “Never loan money to friends. You’ll lose your money and your friends.”

Reminder: Last week, April shared tips on how to loan money to friends and family without ruining the relationship, and 150 GRS commenters added their tips to the discussion.

In its modern incarnation, peer-to-peer lending has gone online, where it’s become a big business. Third-party websites match lenders to borrowers, in an attempt to make both parties feel more at ease.

  • Borrowers at peer-to-peer lending sites get better interest rates and loan terms than they would from a commercial bank. The lending sites will only work with you if your credit score is in the mid-600s or higher, but the terms you’ll be offered are better than most banks.
  • As a lender, you get to know something about the borrower before you lend your money, which builds trust and feels good. But if the loan doesn’t work out and you lose your cash, at least you don’t have to face the deadbeat over Thanksgiving dinner every year for the rest of time.

Peer-to-peer lending has gained a lot of attention because of its purportedly fabulous returns. Lending Club is advertising investor rates of return in the 9% range. Prosper says their returns are slightly over 10%. That’s an order of magnitude better than the return I’m getting on my savings account. Where can I sign up?

The Complete Idiot’s Guide to Peer-to-Peer Lending
To learn more about peer-to-peer lending, I recently interviewed Beverly Harzog, co-author of The Complete Idiot’s Guide To Peer-to-Peer Lending. She had some words of caution before I chase after this pot of gold. Peer-to-peer lending can be great, she said, but it’s not without pitfalls.

“It’s very risky. It’s like investing in the stock market. Everybody may have great intentions, but when you’re lending this money, you have to be prepared to lose it,” Harzog said.

Her bottom line: Don’t invest any money you can’t afford to lose. This might be a good investment, but it’s not an a sure-fire way to make a mint. It’s an at-risk investment just like stocks.

Unlike in the stock market, you’re funding loans. The borrowers have a legal commitment to pay you back at the interest rate you agreed to. If they don’t, the website that set up the loan will pursue your funds through a collection agency. In theory, this should make these investments more secure than stocks, but Herzog warns that you can still lose your money.

To combat that, she suggests lenders diversify their risks, just as they would with stocks. Don’t put $1,000 into one loan. Put $100 into 10 different loans. It’s unlikely they’ll all default, and you’ll earn a nice rate on most of your money that way. You can also choose to only partially fund a loan; when several people fund a single loan, everyone shoulders a bit of risk instead of one person taking it all.

As another incentive, you’ll earn the warm cozy feel that comes from directly helping others. Harzog says this feeling of reaching out and helping is what draws many investors into peer-to-peer lending.

“There’s an element of people helping people that’s just so appealing,” Harzog said. “It’s a very feel-good thing.”

If you want to try peer-to-peer lending, Harzog strongly recommends sticking with the big sites like Lending Club and Prosper. You can start out as a lender at Lending Club for as little as $100. That’s a low bar to entry for new investors. Harzog has seen a lot of smaller sites come and go, while the big ones now have enough gravity to stick around.

Creative Uses for Cash
There are some smaller sites worth noting, though. Some people are putting the basic concept of peer-to-peer lending to incredibly creative uses.

  • Some sites, like Green Note and People Capital specialize in funding student loans.
  • At sites like Kiva, you can help women in the developing world start their own businesses.
  • At Kickstarter.com, you can give money to creative projects ranging from film products to entrepreneurial gadgets. Kickstarter is more about donations than loans, but many of the Kickstarter projects offer a small return in the form of copies of the creative work produced, or your own personal widget when they get made.

These creative sites might not offer the returns a big site like Lending Club does, but they’re fun, interesting uses of the concept. They let you participate for very little money. You can take $25 to Kiva or Kickstarter and invest it in someone’s new business. And at Kickstarter, you’ll get a funky wristwatch or a new folk album, depending on what you invested in. (J.D. helped fund Kind of Bloop, an 8-bit Miles Davis tribute album.)

At this point, I’m intrigued enough by peer-to-peer lending that I’d like to try it. There’s just one catch: I can’t. At least, I can’t play with the big fish. Both Lending Club and Prosper are only available to lenders in certain states, and I don’t live in one of the eligible areas.

Have you tried peer-to-peer lending? What was your experience like? Are you tempted to try it? If not, what holds you back?

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