Your Finance: Peer-to-peer loan market investing tips

Less than a decade ago, peer-to-peer lending came Less than a decade ago, peer-to-peer lending came to the United States as an upstart enterprise -- a service that would in a very personal way link would-be borrowers with individual lenders and bypass the banking industry. Photo Credit: iStock

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Less than a decade ago, peer-to-peer lending came to the United States as an upstart enterprise -- a service that would in a very personal way link would-be borrowers with individual lenders and bypass the banking industry.

The theory was that by cutting out the middle man, online P2P services like Lending Club and Prosper could create a "win-win" situation: Credit-challenged borrowers who needed money for school, to buy a car or put on a roof could obtain loans at less-than-credit-card rates. Lenders, in turn, could cash in on better interest rates than their bank accounts would pay.

The start, however, was rocky. The business was marred by high default rates that went stratospheric during the credit crisis, and borrowers lost interest -- in both senses of the word.

Now, P2P is reborn, busier than ever, with backing from some brand-name investors and even the banks that were once shut out of the business model.

Both Lending Club and Prosper say they placed a record number of new loans in April, with the former at $140 million in loans and the latter at $20 million. While that still may represent only a drop in the broader consumer-finance bucket, it is attracting attention and more money. By acting as intermediaries, the lending services collect fees ranging from 1 to 5 percent from borrowers.

The industry has won some high-profile endorsements of sorts. Google Inc. led a $125 million refinancing of Lending Club in May, and former U.S. Treasury Secretary Lawrence Summers serves on the company's board, for example. Prosper has picked up new venture funding.

But it is not just the venture funding that is distinguishing the new era of P2P -- it is the involvement of a new breed of lenders. With bonds disappointing and bank instrument interest rates near record lows, professional investors are lending through major P2P sites to bolster their returns.

Do new respectability and high yields mean individual investors should jump in and start lending too? Here is what you need to consider:

Pesky default rates. Peer-to-peer lending sports high interest rates because the loans are unsecured with any collateral and the risks of default can be high.

Lending Club says its annual default rate is around 3 percent -- below the 3.6 percent default rate in the credit card industry. But default rates were as high as 13 percent in 2009-2010, according to an independent analysis by the Lend Academy blog, an independent website that monitors the P2P industry. And during the 2007-2009 recession, rates were even more troubling, going over 30 percent in some months.

Prosper's head of global institutional sales, Ron Suber, says that in 2007, the loan process worked differently and that the vetting practices that led to high default rates have now been improved.

Lending Club says that it now has a two-step vetting process that weeds out 90 percent of applicants, making the remaining pool safer.

Both Prosper and Lending Club post credit scores for borrowers, and lenders can use that information as well as income and home ownership reports to pick the loans they want to supply.

You can also check third-party websites like Nickel Steamroller (http://nickelsteamroller.com), which uses data analysis to predict which loans will be successfully repaid in full.

Prosper's Suber adds that his company is keeping growth of loan volume at 15 to 20 percent per year on purpose. "We all could grow even faster than this, but we're maintaining good quality and servicing."

All that vetting may make the loans safer, but it contributes to the shorter supply of loans now available.

Diversification. To minimize the risks of default, experts recommend that investors stay highly diversified, lending around $25 to each borrower in their portfolio. That makes it hard for individual investors to manage any decent-sized portfolio -- there are a lot of borrowers to check out and payments to follow.

Furthermore, the most successful lenders have huge loan lists. Peter Renton, publisher of the Lend Academy blog, has $200,000 invested among 4,000 loans spread between six accounts on Lending Club and Prosper. His rate of return is 10.8 percent, according to his latest quarterly statements. (Renton also gets paid when people click through from his site to one of the P2P sites.)

Lending Club says that every investor with at least 800 loans (requiring a minimum investment of $20,000) has had positive returns.

Perspective. "People see ads on the sites that people are making 15 percent returns, and they want some of that," says Doug Nordman, a financial advice blogger who has tried out peer-to-peer lending and written extensively about it. But it is extremely hard for an untrained individual to manage the process and score that kind of return, he said.

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