Alternative Investments: How to Get 12% Returns (Or More) Through Peer-to-Peer Lending

By | July 23, 2012

I recently stumbled across this type of investment on another financial blog site. The site is called Lending Club. Lending Club is headquartered in San Francisco to help give borrowers lowered borrowing costs while giving lenders a preferred rate of return. Lending Club was founded in 2006 by Renaud Laplanche. Renaud got the idea for this business when he noticed that his credit card carried an 18% interest rate while only earning 1.5% from a bank CD. If he could somehow connect investors to borrowers and circumvent the banks, the borrowers could have a lower interest rate while the investor can have a higher one. And that is how lending club started.

Update: I recently started to invest in Lending Club and got a 7.82% return in 3 months. I wrote an article about it here.

 

How it works:
Lending Club. offers peer-to-peer loans for people who need money and have good credit. Many times, the rates that the bank charges are way too high. Especially if they only need $1000-$10,000. Luckily they can borrow the money from other investors through lending club and get a lower interest rate. In order to get started, Lending Club allows borrowers to apply/create a loan listing while disclosing their personal financial information. Things like credit score, assets, debt, debt ratios, credit history, ect. All loans are unsecured personal loans ranging from $1,000 to $35,000. Lending Club then approves the borrower (declining suspicious or low quality borrowers and generally, only borrowers with FICO score of 660 or higher are approved for loans), and assigns a credit grade (A being the highest and F being the lowest). Most loans average three years, but 5 years or more are available at a higher interest rate. Loans can also be prepaid without penalty.

As the investor, you can browse the site Lending Club. and select the loans you want to invest in. The minimum investment is $25 per note and interest rates vary from 6% to 30%.

I was very intrigued with this type of investment, and it looks like a good candidate for alternative investing. If you already invest in the stock market, or are looking to diversify your risk, then investing in consumer debt maybe a good choice as long as you are educated in how to assess the credit risk (or the risk associated with the borrower repaying its debt obligations). With yields as high (and many cases higher) than 15%, an investor must be very shrewd in what to look for.

What’s the Risk Involved?

Because you’re going to be earning a high interest rate (average is 9-10% interest), there is obviously more risk and thus more due diligence required on your part. This means, you will need to be picky on which borrowers you want to lend to and look at their income, credit history, debt ratios, and trustworthiness. In my experience, If you educate yourself and research properly, you can compensate for the extra credit risk when compared to that savings account. If for example you are really risk adverse, you could stick to lower interest rate loans (7-8%), and probably will be fine.

One thing Lending Club.  is good at is that they are extremely transparent with the information that they share. The company wants to fully disclose all of the risks so that you can be confident in your investment with them.

Lending Club is also very picky when it comes to approving borrowers, since its its inception in 2007, they have denied approximately 90%. This goes to show you that they have weeded out the bad borrowers and have a rigorous approach to finding the select ones.

You’re probably also wondering – how often do people default on their loans? The default rate will vary along with the riskiness of the borrower (the higher the interest rate, the higher the risk).

Here’s a graph showing the default rate since inception by lending club.

% Of Loans Defaulted (By Grade)

A – 1.05%

B – 3.31%

C – 5.24%

D – 6.36%

E – 9.35%

F – 15.79%

G – 17.72%

As you can see, the risk (and interest rate) increases significantly as you move down the lower grade loans, so stick to the quality ratings if you are worried about default. Check out LendingClub.com if you are interested in this type of alternative investment.

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