Peer to Peer Lending for Frugal Investors

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I had been part of the online frugality movement for a few years before I ever encountered peer to peer lending. I was one of those guys who was thrilled by blogs that taught good ways to create a budget, maximize in-store coupons, and get free flights with flier miles. Interestingly, within that entire scene, there really was not a frugal approach to investing. Those same people who taught me the importance of tracking my expenses down to the penny and establishing an emergency fund would then turn around and invest their 401k with Merrill Lynch.

Nothing against the major investment firms, but I was certain I could do better. Their hands-off approach to investing was what I was trying to avoid! Frugality, in contrast, had taught me how to make my finances a more involved process that valued study and patience. Surely there were investing avenues along a similar line.

I began to do a bit more research. I studied socially-responsible mutual funds and opened my first Roth IRA with one of them. I dabbled in the hands-on madness of stocks. But everything changed when, while searching the corners of the web, I happened upon peer to peer lending.

A Better More-Frugal Way to Invest

What I found amazed me. Peer to peer lending satisfied all the different requirements I was looking for and more.

  • Patient growth – Peer to peer lending is not a way to get rich quick, so it keeps away most of the crazies. Instead, what you find is a community of thoughtful people who have been slowly getting consistent positive returns of over 7%. Its volatility is so low that, at times, peer to peer lending can be a refreshingly boring way to watch your savings grow.
  • Hard work is rewarded with higher returns – Investing in the stock market can be frustrating. You can do all your homework correctly to find that perfect mutual fund, and yet if a national index like the S&P 500 drops, you will probably lose money as well. In contrast, peer to peer lending rewards its studious lenders with more positive returns, even during an economic downturn like 2008. Furthermore, you can learn how to target borrowers using statistical filters and, as a result, experience far fewer defaults (loans that fail repayment). My main Lending Club account is earning a return above 15% using a customized filter.
  • Ease of Entry – You need little cash to get started. This is because you do not fund entire loans yourself. You purchase notes, or portions of each loan, and a note can be as small as $25. This way, loans as large as $35,000 can be funded by hundreds of lenders, both well-funded and not, all working together to issue loans to people nationwide.
  • Social Responsibility – One thing I loved about the frugal movement was how it emphasized that relationships and experiences (not cash) are what make life worth living. Helping others out is a deeply rewarding way to spend our time. Interestingly, the majority of loans in peer to peer lending help people get out of the debts they incurred with their credit cards, giving them a single payment with a lower interest rate. Everybody wins.
  • Tax-free Options – I often struggled to figure out the Schedule D forms involved with an active stock portfolio each tax season. With peer to peer lending, both major platforms offer IRA accounts options. It is hard for me to believe that I am earning so high of a return at Lending Club tax-free; the compounding really gains momentum within an IRA.

Drawbacks

There are some risks in peer to peer lending, so people need to consider these carefully before getting involved:

  • Peer to peer lending is new and unfamiliar – This industry did not even exist ten years ago, so people are understandably hesitant to start investing their hard-earned savings in something they hardly understand. But there really are no risk-free investments in the world, and I feel the years of loan history averaging a 7% return is proof of its validity. Plus, while the lending process might seem complicated at first, it is actually quite easy to understand with a bit of time given to it.
  • People might lose money – This happens daily on these sites. However, if you diversify your account among two hundred loans or more, a negative return is extremely rare. When I studied the importance of peer to peer lending diversification last month, I found that, out of 3800 lenders who invested in at least 200 different loans, only four lost money. In contrast, filtering the platforms with a few simple filters (like not lending to those with a past bankruptcy) can mean a diversified account almost certainly earns at or above the 7% average.
  • The platforms may go bankrupt – This is a valid concern. There really is no precedent for what might happen if a peer to peer lending company goes bankrupt. Do the lenders keep their loans? Do they get swallowed up by the bankruptcy settlement? Nobody knows for sure. However, Lending Club (the industry leader) is experiencing such tremendous success for the past few years that a bankruptcy looks extremely rare these days. Furthermore, Prosper (the other option) just came out with a protection vehicle that should save borrowers in the event of a bankruptcy.
  • Interest Rates May Rise – If savings account rates climb out of the gutter they are in today and rise substantially in the coming years, say to 7%, you will be hard pressed get lenders to invest in A-grade borrowers (those with the best credit). These peer to peer loans have a return of around 6-7% and do not have FDIC protection like a savings account. That said, I do not see rates climbing too dramatically, and believe that the peer to peer industry will adjust, even if this happens

Having looked at the benefits and drawbacks of peer to peer lending, having poured over websites and statistics for hours on end, I can honestly say that I am thrilled for what is happening. I transferred my Roth IRA over to Lending Club and recently began a peer to peer lending blog to teach people how to get involved themselves. Today, I have accounts with both Lending Club and Prosper, and each month leaves me more and more convinced that this is a healthy breakthrough that the country needs to hear.

Slowly Making Headlines

What amazes me is that, despite my enthusiasm, I have yet to meet anybody who knew about peer to peer lending before I explained it to them. Most people still think I am talking about micro loans to the third-world through sites like Kiva.

But this situation is changing, and quickly. The industry recently crossed the $2 billion mark in total issued loans, having crossed $1 billion mark just nine months ago. That kind of growth has not been seen since the introduction of ETFs in 1993, an industry that grew to more than a trillion dollars in 20 years. If this momentum stays the same, people are bound to hear more about peer to peer lending in the coming years.

My hope is that it eventually becomes a mainstream practice that gets people out of the volatile stock market and into the peace of lending money to one another. Imagine this financial connection spreading beyond personal loans, for instance into loans to businesses. There is so much debt around the country that could be eased through socially-responsible crowd funding. The party is barely getting started.

What do you think about the peer to peer lending business? Feel free to share your comments and opinions below.

Learn more about peer to peer lending at the LendingMemo website. I have a free 35-page eBook guide available that explains the entire process in detail so that just about anybody can get involved.

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