My peer-to-peer lending experiment earns high yields

pink piggy bank on a blue background

Four months into my peer-to-peer lending experiment, I'm netting a 9.49% annualized return on my money.

That's not bad for cash I previously had sitting in a savings account earning less than 1%.

After reading about P2P lending investments for more than a year, I opened an account at Lending Club earlier this year and deposited $1,000.

With such a small investment, I'm not making much money, but that's OK because I'm just testing out this concept.

In P2P lending, you essentially act as the bank by lending money and earning a return off the interest.

Our 5 facts about peer-to-peer lending will give you a good idea of the risks and rewards.

I've decided to make a bunch of small loans to spread my risk and minimize the impact of defaults.

My logic: If I make one big loan and it defaults, I would lose my entire investment. But if I make dozens of small loans and one defaults, I would only lose a portion of my investment.

Average Borrower Profile

  • 705 FICO score
  • 15.8% debt-to-income ratio (excluding mortgage)
  • 14.6 years of credit history
  • $70,941 personal income
  • $13,096 loan size
  • Source: Lending Club, as of May 13, 2013

    At Lending Club, the minimum amount you can loan is $25 per note, so when I've fully invested my $1,000 deposit, I'll have about 40 loans.

    I've been buying about two notes per week, carefully picking the ones I want as they come available, based on factors ranging from employment and credit score to debt ratios.

    Higher-risk loans offer higher yields, and I may take on more risk later. But for now, I'm using a relatively conservative strategy, focusing on loans to which Lending Club has assigned an A or B grade, which pay lower interest rates because they're seen as less risky.

    As of mid-June, I had 29 notes in my portfolio: 57% in A-grade notes, 35% in B-grade notes and 8% in C-grade notes.

    I've received $62.39 in payments, and I have $672.73 in outstanding principal.

    Chart showing the average net annualized return by loan gradeI'm looking for these attributes in anyone I lend money:

    Finally, I only invest in notes for credit card refinancing.

    I don't do car loans, business loans, home improvement loans or loans for vacations or nonessential items.

    I like credit card refinance loans because they make sense. Most of these are people with good FICO scores who are trying to dump credit card debt they acquired in the past.

    Not all people with credit card debt are irresponsible deadbeats or late-payers.

    Stuff happens in life. A car accident, the AC unit breaking down at home or a layoff can easily drive a person to plastic.

    In any case, they're coming to Lending Club because they can borrow for as little as 7% and pay off cards that are charging them 15%.

    It makes sense for them as a borrower, and it makes sense for me as a lender.

    One of the risks with high-grade notes is that they'll pay off the note before the term is up, meaning you'll earn less in interest.

    That has already happened for me.

    A borrower paid off a loan earning 6.03% in only one month. In that case, my $25 investment earned me $0.13 in interest.

    A bigger concern is the risk of default.

    So far, I've had up to four payments on some of my oldest loans. All of the payments have been on time.

    But based on the available P2P historical data and the portfolio I'm holding, I should expect one or two defaults.

    Based on the money I have outstanding and the principal and interest I've received, I'm on track to earn 9.49%. This number includes defaults that Lending Club says I can expect.

    But even factoring in a couple of defaults, I'll still come out far ahead when compared to what I would earn on my money in a savings account.

    With CD rates this low, take on some risk in 2013

    Savers need to consider other investments: With CD rates at record lows, it's no longer possible to earn a decent return without taking on some risk. Still, you can invest smartly and minimize that risk.

    Some options:

    • Dividend-paying stocks
    • International bond funds

    For me, the biggest downside with P2P lending investment is the loss of liquidity.

    You can't seamlessly cash out a CD or bond before maturity, but the entire investment will keep earning money until the term is up.

    With P2P lending, to keep the return going, you continually have to reinvest by buying new notes with the payments you receive from existing notes.

    Your money could be tied up indefinitely. Or at least until you generate enough to withdraw your entire initial investment.

    There is a trading platform to sell notes, but you'll have to pay a 1% commission and sell them below face value.

    No matter how things go, I couldn't see myself having more than a few thousand dollars tied up in this investment.

    One final risk is that there could be better alternatives to earn a yield when interest rates start to rise.

    Nine percent sounds amazing, but if I could earn an FDIC-insured 6% in a bank again, I'd go back to that in a heartbeat.

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