A brief intro to peer-to-peer lending

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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Derek
Derek
9 years ago

My friend has tried P2P lending online. He was just testing it out and put in like, $50. It went pretty good for a while, but then his lendees began to default on their payments. Supposedly, the site would automatically try to receive payment by legal action, but I don’t think my friend saw anymore of his money. I don’t think it was a bad idea, but I don’t think people take this repayment as seriously as they would a bank. If you choose to invest with this method, you want to make sure to choose those with a good… Read more »

Rob Ward
Rob Ward
9 years ago

I invested about $300in prosper a few years ago. I invested no more than $50 for each loan. Every loan has been paid on timewiththe exception of one that has defaulted. So, I only lost about $50. Since I initially signed up however I can no longer invest with prosper in my state.

John
John
6 years ago
Reply to  Rob Ward

So you invested $300, had the potential of making $30, but ended up losing $50. Sounds like a negative rate of return to me.

max
max
9 years ago

i’m doing p2p lending for 3 years now. i’ve invested about $ 7000 over the years. right now i have a return rate from about 8%. i constantly reinvest the monthly payments back into the system. the monthly payment (amortisation + interest) is approximately $ 350. some tips for starters: do it slow. do not fire $ 10.000 at once in p2p lending. you need the time to read the project description and evaluate the projects which fail. over time you get a better hand finding good projects. also keep in mind, 10% of the projects will fail, spread the… Read more »

Russ
Russ
9 years ago

Here in the UK I use Zopa (http://uk.zopa.com), and I can’t recommend it enough. In over 3 years, I’ve loaned to almost 180 borrowers in £10 chunks and have an average return of 8%, without a single default. I have had a small number of late repayments, but they pay up eventually. They’ve also recently introduced functionality that allows you to sell your loan to other lenders and get your money out quick if you need to, so as an investment vehicle it’s now much more liquid and I’ll be putting more money in this year. /not a zopa astroturfer,… Read more »

indio
indio
9 years ago

Using Kiva, I lent money to a woman in Cambodia, who was starting a business and needed financing. I know the work ethic and moral responsibility (honesty and trust) in the region so losing the money wasn’t a concern. She was raising $1k which required multiple people donating to help her out. She paid the loan back and I reinvested it all in someone else. It’s not a huge amount of money so as long as it gets paid back, I will keep putting it back into business plans to help other people.

Nicole
Nicole
9 years ago

Interesting post. Though Kiva isn’t exactly an investment– you will not get any returns on your money. The way that Kiva works, though, you will get your principal back if you want it (most people let it float). You are essentially donating any interest you would have gotten on money if you had put it in a different investment. From what I understand from people who study it, Kiva loans have actually already been funded and your loan is reimbursing the organization. Additionally, the NGOs that bring the loans to Kiva will repay them no matter what. If they don’t,… Read more »

Andrea
Andrea
9 years ago

Kiva is an investment in bettering the world-yes, charity but for those who are trying to find a way to better support themselves, their family and community now and in the future. There is the possibility of default- it happened on one loan but as it is really a charity(in my mind)- the money went to someone who needed it but whose small business failed.

I just never wanted to mess with actual p2p loans

JakeIL7
JakeIL7
9 years ago

One thing that is not discussed here is the level of effort required to select loans versus the (minimal) level of effort of investing in index funds (stocks or bonds).

I think these places have a use and can be good for those looking to offer others a hand up, but as an investment strategy? Nah.

Egg
Egg
9 years ago

I looked into this a while back and am in one of the states that restricts my participation. The rule in KY is that you have to have an individual net worth of greater than $1 million or an income of greater than $200K/yr. I asked state officials why the rule to help the rich get richer, but let the little guy suffer? I was told the state law mirrors federal law 17 CFR 230.501(a). So how are so many people using these P2P lending sites? Am I that much poorer than everyone else or are they breaking the law?

Adam
Adam
9 years ago

I signed up for Prosper in early 2008 and lent out about 3k. On the negative side, I lost money on my loans (about 2%) due to defaults. I made about 70 different loans with the money and had some fun doing it. On the plus side, I also invested about 3k in stocks at the same time and lost much more than 2%. After Prosper shut down for a year for regulatory changes, I’ve visited again but haven’t really lended. At this point, there just aren’t enough high quality borrowers on the site that I would want to lend… Read more »

Peter Renton
Peter Renton
9 years ago

I am surprised by some of Herzog’s comments. I own her book and while it is a good introduction to the concept of peer to peer lending, much of it is now completely out of date. I think Herzog is also viewing peer to peer lending from the way it was in 2007 and 2008. Back then default rates were still very high and many investors lost money. Let’s fast forward to 2011. Now, the return on all notes in Lending Club is 9.68% and Prosper is over 10% since their reintroduction in 2009. The vast majority of peer to… Read more »

Micah
Micah
9 years ago

I actually am currently involved in P2P lending at Lending Club. After reading an article about P2P lending, and tracking with the author, I decided to take $500 and invest it into as many “notes” (loans) as possible. That said, I followed some basic rules that I think will help hedge my bets (if possible) against defaults. 1. No notes requesting over $20,000 2. No notes for income less than $100K 3. No notes for less than 5 years of employment with current employer. 4. Preference to government employees/military (only because I assumed to be safer) 5. $25 per note…creating… Read more »

sarah
sarah
9 years ago

This doesn’t sound like something I’d want to do, although I do use Kiva. To be clear, you don’t earn money there. The whole point is that the loans are interest-free.

Timmy Lane
Timmy Lane
9 years ago

I tried it with Prosper a couple of years ago. I invested $1000 funding $100 to 10 loans. 4 of the 10 defaulted. I won’t try it again.

Jake @ NotRichYet
Jake @ NotRichYet
9 years ago

The issue with P2P lending in my eyes is the effort required to invest the money. You need to spend serious time screening and then researching loans you want to invest in. And then, you should only invest a fraction of your portfolio. The more you invest, the more you should diversify. So once you are talking “real” money, you need to be spending a lot of time grooming and reinvesting your money. That can quickly amount to several hours of work per month or week. You need to trade that off vs. other things you could do with that… Read more »

Money Maker
Money Maker
9 years ago

Is this post a sponsored advertisment, or does this site have financial relationship with any of the peer-to-peer programs? I have been interested in lending in a peer-to-peer program but almost all of the information available about it is thinly veiled advertorials on blogs, and the whole thing seem likes a very shady pyramid scheme to me. I would be interested in finding neutral, non-commercial information on this. Since this blog is a commercial blog (and one which keeps the identifies of its sponsors tightly shrouded in secrecy), I am skeptical of this blog to deliver unbiased reviews of financial… Read more »

Panda
Panda
9 years ago

Re Money Maker above – Maybe I’m naive, but that’s never been my impression of this blog at all.

Allie
Allie
9 years ago

I’ve been using Kiva for about two years now. I contribute in small amounts ($50) once a month. I try to shake up what/who I invest in (long-term vs short-term loans, women vs men, where they are, what they want the loan for, etc). Although I currently have two loans defaulting, that doesn’t mean they’ll end in a loss. I’ve had loans that were defaulting before and caught up on a later repayment. Also, by spreading out where I invest in small amounts, it diminishes the likelihood of losing a lot of money. That all being said, I donate with… Read more »

Mary H
Mary H
9 years ago

@Peter Renton & Micah
Sounds like you’re both doing well with this. How much time do you figure you spend on this type of investing?

Peter Renton
Peter Renton
9 years ago

@Mary, I have a system where I use filters to find new loans. I download the new loans spreadsheet in LC and with Prosper I use the filters on the site. I reinvest all my new cash generated from repayments and my actual time spent investing is about half an hour every two weeks. Of course, it took me a while to learn what I was doing.

Full disclosure: I author a blog about p2p lending (you can click on my name above to get to my site) so I am not your average p2p investor.

Tyler Karaszewski
Tyler Karaszewski
9 years ago

This sounds both incredibly risky (who applies for these small but high interest loans instead of just getting a credit card? People who can’t get credit cards? Why can’t they get credit cards?) and like it has poor returns and ridiculous overhead. People are talking about getting 9-10-12-13% *since 2009*. That’s less than just investing in the Dow Jones. Your returns would be better in the stock market, and there’s absolutely no indication that the returns on these loans wouldn’t drop correspondingly with a drop in the stock market (which may be associated with layoffs, deferred bonuses, and lots of… Read more »

Meghan
Meghan
9 years ago

I used Lending Club to receive a $5k loan. I am grateful for every individual that lent to me. I used the $5k to close a credit card account ($4k with 24% interest rate and $90/yearly fee) and used the remaining $800 ($5k less fees) to take an education course to help me pass my Professional Engineering exam. It took a while to figure out if I really wanted to do it, but I’m able to pay off this amount in 3-years at a lower interest rate and set monthly payments then paying off my credit card over the next… Read more »

James
James
9 years ago

I got in on Prosper right from the beginning. Luckily, I got out with only minimal losses. I’ll never do it again. For an honest accounting of what really goes on for Prosper lenders and what the rates of return really are, I urge everyone to read Fred93’s Blog. He was one of the early “bigtime” Prosper lenders and has done extensive research into the platform.

http://fred93blog.blogspot.com/

Just a quote from his latest entry:

“The worst month so far is still February ’07. Of the loans originated by Prosper.com in February ’07, 45.3% have now gone bad. Yipes!”

Peter Renton
Peter Renton
9 years ago

@Tyler, You are correct for large investors it would be terribly time consuming to look through thousands of loans. The best idea for people with $25,000 or more is to use one of the automated plans that diversifies your money evenly among loans, or you can use a filtering system where you filter out the loans likely to give a poor ROI. I completely disagree that p2p lending is like the stock market. If you to draw a comparison with another investment vehicle bonds would be closest. A diversified p2p investor is going see their balance grow every month, something… Read more »

Luke
Luke
9 years ago

Like Russ @ #4, I’m another British Zopa fan. The trick to avoid losses is definitely to diversify and I also stuck to £10 loans (the minimum allowed) to the maximum number of people I could afford to lend to. I’ve used the facility that he mentions (Zopa allow you to resell all loans in a given risk market minus a small fee) and it helped me pay off some expenses for my forthcoming wedding. All in all a positive experience and I hope to invest £200-300/mth once I’m married and have better cashflow. One thing that needs to be… Read more »

Adam
Adam
9 years ago

I have been using Lending Club for about 2 years now. I started with a free $25 promotion, and invested that in a single note. After a few months of watching how the process worked, I began to fund my account with $50 per month. Every note I invest in is in $25 increments, and meets a personal set of investment standards. Most of my standards are easily sortable with Lending Club’s browse notes feature, and the time investment is really quite minimal. With well over 50 notes now, I have been fortunate to have zero defaults, as well as… Read more »

Tony
Tony
9 years ago

I invested $4,000 in Prosper back in 2008. I funded 80 loans of $50 each. So far 23 loans have defaulted. Including the gains from the interest minus the losses from defaults I’m down about $120. I won’t invest anymore, I’m just cashing out my money every month until the last loan is paid-off. I used their “Mid-Risk Portfolio”. One thing I have noticed is that once the loan goes into collections it’s never collected, their collections agencies must have a pretty bad performance record. These defaulted loans eventually end up charged off in bankrupcy. My advice: don’t invest you… Read more »

Andy Hough
Andy Hough
9 years ago

I’ve managed to get over 10% returns from both Prosper and Lending Club but I only keep a small amount of my portfolio in both of them.

The one loan I made on Kiva defaulted but I hope it did the borrower some good.

Karen
Karen
9 years ago

I’ve got about $1700 in Prosper and Lending Club. I started out with Prosper, but I prefer Lending Club’s more extensive filtering capability, so I am gradually shifting my funds there. I’ve been averaging around 10% returns and have had only one default (on Prosper) — I joined after both sites came back up after getting SEC registration. The few other times I’ve had late payments it was due to an automatic payment failure that was then promptly replaced with a manual payment, then the borrower went back to automatic. I assume the borrower(s) closed a bank account and forgot… Read more »

Joel
Joel
9 years ago

I love Kiva. Such a good cause and micro-finance has such a big opportunity to change lives in the developing world.

Des
Des
9 years ago

I don’t put much stock in anyone’s experience pre-2009, as a lot of changes went in at that time. I invested with Prosper from 2006-2008 and, like many investors of that time frame, lost money. Even still, I know that the platforms have changed since then and I’d be willing to do it again. Should you cash out all your index funds and dump all of it into P2P? No, but it is a way to diversify. Do you really want *all* your investments in stocks? RE: Tyler – I see your point about why would someone want to borrow… Read more »

Storch Money
Storch Money
9 years ago

I’ve had a 40-note portfolio with Lending Club since 2009. As of today, my annualized return has been 4.79%. I’ve had 3 of 40 notes default, which hurt the return considerably. I’m undecided on whether I’ll invest more in the future. I do think Lending Club is an interesting and legitimate investment. The credit standards Lending Club imposes are strict and the borrowers are not just people who can’t get credit cards. Many want to pay off credit cards. Others just don’t want to borrow from major banks or credit card companies. The time required to hand-pick notes would be… Read more »

J.Dot
J.Dot
9 years ago

I’ve used Prosper, for the last 2 years and over 30 loans. I haven’t had one default. The loans I pick are high quality AA & A with long credit history. My returns are 9% and my loans are ultra conservative. I have had a friend or two lose money with Prosper mostly due to high risk loans. I use Prosper as a replacement (for now) for short terms cd’s. Great return and a joy to give people who deserve it, a better rate.

PigPennies
PigPennies
9 years ago

The main question I would have before investing in a P2P is do these loans appear on your credit report? @Des, perhaps you answered that in your post since you took out a $1000 loan from Prosper to build credit. Does that mean the loan did appear on your credit report?

I would think that this would have a big impact on the likelihood of default, particularly for those with credit scores above 700.

Roo
Roo
9 years ago

I use Kiva! Like Allie #18, I use it more as another bank account. It’s a place to put money away when I have money, and have it trickle back so when I need it it’s there.

I really want to try Zopa though. I am having problems getting part time work to fit around university, so maybe Zopa could help pay my bills?

Nick (Macheesmo)
Nick (Macheesmo)
9 years ago

This sounds really interesting. I’m gonna give Lending club a shot with a few spare bucks and see how it goes.

I can see this as a nice diversification strategy in a portfolio, plus I can see how it would be fun to select loans and hopefully help people out.

LC
LC
9 years ago

I gave Kiva cards instead of gift cards to my siblings for Christmas this year. Since we have all been so blessed materially, Christmas was beginning to feel like an obligation to give something when there was nothing any of us really needed. I decided that Kiva cards were a great way to give a gift that impacted not only the receiver, but also someone else in need. After investing once, each of my siblings can either continue giving (lending) to other people or pull the money out and use it for a need or want. The gifts were so… Read more »

J.D. Roth
J.D. Roth
9 years ago

@Money Maker (#16) You routinely make unsubstantiated (and false) suppositions and accusations about me and this blog. In the past, you’ve written that I must make half a million a year from Get Rich Slowly, and that therefor I must be spending a quarter of a million dollars per year on comic books and other stuff. You also recently wrote that you weren’t surprised to hear that I’m back in debt — even though I’m not (nor anywhere close). And now you’re insinuating that this is somehow a paid post. Well, all of your accusations and suppositions are incorrect, and… Read more »

Sarah
Sarah
9 years ago

I would be wary – stories like this are starting to surface: http://www.npr.org/2010/12/31/132497267/indias-poor-reel-under-microfinance-debt-burden

El Nerdo
El Nerdo
9 years ago

I don’t want any more debt for the rest of my life, ever, so hopefully I will never have to consider getting a P2P loan. Kiva on the other hand sounds like a nice alternative to charity, helping people get out of poverty by giving them access to capital. Then again maybe they aren’t really getting out of poverty but temporarily “leveraging” their standard of living? I don’t know how this works. I do know that a large part of the 3rd world is terminally indentured to the World Band and International Monetary Fund because of “credit for development” that… Read more »

brooklyn money
brooklyn money
9 years ago

I just started using Lending Club. I think for investors with a lot of cash with nowhere to put it, this can be a good solution. I started with just I think like $1K, but I plan to add more over time.

Lou Lamoureux
Lou Lamoureux
9 years ago

Speaking from personal experience with Lending Club and the stock market, you have to do your homework. You can’t just pick stocks or loans willy nilly. I’ve done some research based on Lending Club’s loan data to determine which filters are better than others when picking loans, but there is no one filter that will guarantee success so diversify and expect some losses. I would recommend to anyone who lends on LC to download the data and analyze the failed loans, don’t just rely on guesses and intuition. For instance, Some borrowers only invest in small business, but the data… Read more »

El Nerdo
El Nerdo
9 years ago

@SARAH #39 – Wow, apparently we were writing our posts at the same time so I didn’t get so see your link before I posted my comment, and this in fact goes beyond what I feared– shocking! I don’t think that includes Kiva, but still, the dangers of debt are universal.

Megan
Megan
9 years ago

Just a note: For lending club, you MUST have an income of 70k and a net worth (independent of house, house accessories, and cars) of $70k! (higher in CA) This means, as a grad student, even with money to invest, I cannot participate. I had hoped to use the site to generate more interest than I’m paying in student loans and thus make money but I cannot do that at this time. If you do chose to invest without following these rules, you lose the ability to get your money back if the loan goes to collection (or so I’ve… Read more »

Jane
Jane
9 years ago

@Sarah
Thanks for the link to the NPR story on microlending in India! It sound more like usury to me than lending. I wouldn’t get involved in such a thing, even if we did make enough to qualify. It sounds to me like non-profits alone should be involved in this practice.

anne
anne
9 years ago

Interesting post. I have friend who did something like this a few years ago. She did it through a very good friend who, with a group of people, lent money to carefully selected people who were, for example, going through bankruptcy. She has done quite well. Started out with putting $10,000 into the pot. Again, the borrowers were carefully selected as a good risk, not something all of us can do on our own.

Jason
Jason
9 years ago

Im going on 1.5 years with Lending Club. 157 loans out, 1 defaulted, 2 are 31 days late but on a payment plan which is mostly interest payments. Currently I have about $6000 in and thinking of adding more. I am @ 10.2% return including the default.

Jonathan Swift
Jonathan Swift
9 years ago

I had an interesting experience with peer to peer lending. Owing to unique conditions at my bank- I had the chance to buy back my mortgage debt at a discount to what I owed. They were essentially saying – we need cash now and so are selling assets. I had the money line up, but a friend came to me and desperately needed a large loan for just a week since his net worth was tied up in bonds that he couldn’t access immediately. Poor planning on his part, but I knew he had the money so I loaned the… Read more »

Ray
Ray
9 years ago

Well, I would like to leave a comment from the other side of P2P…I currently have my 3rd and 4th loans from Prosper and I have never been late on a payment on any of the loans. I am thankful that there are companies like this and these loans have helped me greatly reduce my debt and help fix my lower-than-average credit from past mistakes. So to all you P2P lenders, THANKS!!!

Michael
Michael
9 years ago

I started on Lending Club with a $25 promotion about 2 years ago. The biggest problem I had back then was that the loan applications were all for things that I didn’t really think of as good investments. I know that debt consolidation is a needed service, but the little info on the people applying didn’t inspire oodles of confidence that they would pay back the loans. Similar problem for the business startup loans, there weren’t business plans available, so you had to use the forum like system they have to ask specific questions. That’s fine for 1-on-1 loans, but… Read more »

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