Profitable investing with the people
February 15, 2012
If you have a lot of cash on the sidelines, consider an alternative that pays you a higher rate of interest and gives you a cozier feeling than leaving your money with a megabank.
Have we ever seen a gloomier time for savers? Most banks pay paltry rates of interest. Treasury bonds and CDs are little better. Plus most individual investors have soured on stocks with the constant threat of the Euro collapse abroad, and a divided and sclerotic government at home.
If you have a lot of cash on the sidelines, consider an alternative that pays you a higher rate of interest and gives you a cozier feeling than leaving your money with a megabank. It's called peer-to-peer lending, and it's made possible by the scale and accessibility of the Internet.
Lenders such as LendingClub and Prosper enable investors to reach borrowers underserved by mainstream lenders. These sites screen loan applicants, pull credit reports, present the loans to investors and then service the loan. Depending on the loan risk, you could receive 6 to 12 percent annual interest for lending your money for up to five years.
The start of the peer-to-peer lending industry was rather rocky. Prosper was the early dominant provider of these loans before the Great Recession. Just like investors in CDOs found out, the assumptions for loan default rates had not been stress tested for a macro economic collapse. With soaring defaults, there were accusations that lending sites weren't being diligent in pursuing slow-paying borrowers. Charges of selling unlicensed securities to unqualified investors also muddied the waters.
With the entry of LendingClub into the market, the peer-to-peer lending model has improved markedly. Prospectuses are filed with the SEC, late borrowers are pursued with vigor and underwriting criteria has been improved.
The process begins with a borrower applying for a loan, generally under $25,000 for a term of three to five years. Most seek loans for the most prosaic of reasons: consolidating high interest credit card debt. The sites then pull credit reports and decide whether or not the prospective borrower meets their criteria. LendingClub accepts about 10 percent of applicants.
Once the borrower is accepted, these sites assign a loan grade much like the ratings agencies do for a bond. As you would expect, an investor might only earn 6 percent annually with an "A" loan, while a "G" loan would pay closer to 12 percent. Loans are then made available to investors while protecting the identity of the borrowers.
Waiting to have your $10,000 investment come back from a pool loan in Piscataway would be nerve racking. Fortunately investors can spread their risk out by making scores of micro-loans. These sites permit you to invest as little as $25 in hundreds of loans. Once you invest, you get regular payments automatically deposited into your account. If all goes well, you will receive a high rate of interest and the principal back through the three to five year term of the loan.
Ten percent interest. Cutting out the megabanks. Helping a person in need. What's not to like?
Reading through the 98 page prospectus of LendingClub, you can see ample risk factors. While there are reams of data about default rates in the different categories, these lenders are growing so rapidly that most of their loans are relatively new. Trying to predict how a given loan grade will perform is a challenge at this stage.
If you have $5,000 sitting in a bank, you won't need it for the next few years even for an emergency, and take an active role with your investments, then lending $25 to 200 people across the country could be a profitable pursuit for you. Just don't kid yourself that it's a risk free enterprise.
Dave Gardner is a certified financial planner with a practice in Boulder and is the president of Alliance of Cambridge Advisors, a national organization of fee-only financial planners. He can be reached through his website at yellowstonefinancial.com.
Boulder Daily Camera