Peer-to-peer lending offers double-digit returns with some work, risk

Dollar bill folded like a staircase

In normal times, the idea of loaning money to strangers through a website would be a tough sell.

But these are hardly normal times.

With CD rates and the yields on everything from government bonds to money market accounts at record lows, savers are looking for higher returns wherever they can find them.

Peer-to-peer lending is one of those options, if you meet the geographical and financial requirements.

Through websites like Prosper.com and Lendingclub.com, you can invest in short-term loans to borrowers seeking money for everything from eye surgery and home improvements to paying off credit cards and starting a business.

The sites claim their investors, which they call "lenders," earn anywhere from 6% to 18%, even taking into account losses from bad loans that are never repaid.

You'll have to think hard about the loans you want to fund.

For each borrower, there is a description of why they need the loan along with their payment history and a list of other investors who are participating in the loan.

The loans range from one to five years, and borrowers are assigned a credit score that reflects how risky their loan might be.

At Prosper, credit ratings range from AA to HR.

As of February 2012, AA loans, which have a weighted average credit score of 808, have an actual loss rate of only 2.41% and a seasoned return of 5.18%. But those high-risk HR loans, which have an average credit score of 668, have an actual loss rate of 11.04% and a seasoned return of 17.71%.

Since most note defaults occur at five to nine months of age, Prosper uses "seasoned returns" to define those aged 10 months or more.

Lending Club uses "net annualized return" as a measure of return and includes notes three months and older.

At Lending Club, those returns currently range from 5.83% for Grade A notes to 12.4% for Grade G notes.

If you have $20,000 to invest and would rather not go through the hassle of picking loans, Lending Club will offer you a preselected pool of 800 notes.

According to their site, every single investor with 800 or more notes has had positive returns. Almost 92% of them have had returns between 6% and 18%.

Many lenders roll their interest payments into new loans. This allows interest to compound while somewhat preserving the principle.

You can build your own portfolio and get diversification by spreading your money across various loans.

Instead of loaning your $1,000 to one single person, you might loan $50 to 20 different borrowers.

You can also lend to people in different rating categories. You might have 35% of your investment in AA loans, another 35% in B loans and then 30% in higher-risk D loans.

By spreading your investment, you're minimizing the risk. So, if some of your loans default, and it's highly likely that a couple will, you won't lose all of your principle.

The idea is that the losses you suffer in the higher-risk categories will be offset by the more reliable payments in the low-risk categories.

Lenders have pointed out this downside: Borrowers with the highest credit rating often pay off their loans early.

So, while you may have had a pool of 36-month notes earning 6.6%, half of them could end up paying it off in a year, dragging down your total return by a few points.

When a loan is paid off early, you'll have to roll your investment into a new loan if you want to keep earning interest.

Be aware that there are some minimum requirements before you can invest.

At both sites you must be 18 years of age and have a valid Social Security number and checking or savings bank account. The minimum investment to open an account is $25.

Lending Club has "State and Financial Suitability" conditions. You must reside in one of the 28 states where peer-to-peer lending is legal, have a gross annual income of at least $70,000 and a net worth (not including your home) of at least $70,000.

You may also not purchase notes in an amount in excess of 10% of your net worth.

Requirements at Prosper are similar.

There are still 22 states (including Texas, Ohio and North Carolina) where regulations do not allow residents to invest through these loan marketplaces. Both Prosper and Lending Club say they're working with these states to win approval.

Investors do not pay a fee to sign up at either site, but both charge a 1% loan service fee on all amounts paid by the borrowers to the organization.

The best thing is that if you get skittish or want your money back, you can liquidate your investment.

Both sites have trading platforms where you can sell your notes at any time for a 1% transaction fee. You'll likely have to price your note competitively to make it move, but it still offers you a way to get most of your principle back.

The trading platforms also offer an option to buy existing notes, some of which could be good deals and suitable risks.

For example, you might be able to buy a 36-month note that is in its 17th month. You can view the payment history.

If you see that the person has made all of the payments and you have the chance to earn 8%, you might feel comfortable buying the note.

It's a shame that we have to consider risky investments like peer-to-peer lending just to earn a reasonable return on our savings.

But every option has to be on the table when even the best 5-year CDs are only paying 2%.

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