As more consumers become comfortable with idea of borrowing and lending money to each other over the Internet, investments in peer-to-peer loans are emerging as a another way to diversify a portfolio.
But investors beware: The risks associated with these loans can be minimal to very high, in part depending on the credit history of the borrower.
Peer-to-peer Web sites remove the traditional role of the bank from the lending process, allowing borrowers and lenders to connect through the Internet. With less overhead, rates are better on both sides, the sites claim. Popular sites include Prosper, Lending Club and Zopa.
Before dropping a dime into an investment of this sort, it's best to first understand how much risk you're willing to take on, said Jean M. Garascia, associate analyst for Javelin Strategy & Research and author of a research report on the topic.
It may be a basic rule, but it's probably worth noting anyway: "Assume that the higher the return is going to be, the higher the risk is going to be if you're a lender," said Mark Meyer, director of the Filene Research Institute, a research firm for the credit union industry.
Investors willing to fund borrowers with weaker credit histories can see returns in the double-digits; those interested lending to more creditworthy borrowers will achieve lower returns.
But some loans will default, and while the lending community you're working with will likely pursue loan payments through the appropriate channels, it's still very possible to lose money in some cases, Garascia said. So before lending, understand how collections are handled at the site.
It's also worthwhile to note that borrowers have an incentive to succeed: Those who default will often have their credit histories marred by the event -- and their reputation in the lending community will also sour, causing them to be shunned by future investors.
Beyond that, there are ways to make sure a foray into peer-to-peer lending is more likely to be a profitable one. Those interested in making loans may want to consider the following:
1. Understand the model
Peer-to-peer sites have different standards for who is eligible to secure a loan.
One of criteria to borrow at Lending Club (lendingclub.com) is a FICO score of at least 640, while Prosper (prosper.com) doesn't have a minimum score, allowing the market to completely dictate which loans get funded.
Perhaps one of the safest bets is at Zopa (zopa.com), where investors become members of a credit union and are able to insure their investments because funds are put into a certificate of deposit. The tradeoff: Returns on those investments will be comparable to a bank CD, and currently are 5.10%.
Those interested in funding a borrower who they already know might consider Virgin Money (virginmoney.com). This site facilities loans between friends and family members, and, for lenders, helping finance someone they know is usually as important as return on investment.
2. Listen to the stories but don't ignore risk
Peer-to-peer sites often allow borrowers to share their story, explaining why the funds are needed or associating themselves with affinity groups based on classifications including interests, professions and location. While the stories could motivate lenders to invest, don't be blind to the borrower's credit information if the goal is a good return.
Investor TK Baltimore, 33, for example, mainly considered the financial health of borrowers when she had a portfolio of loans generated on Lending Club. The loans were selected based on the amount of risk they entailed, she said.
3. Diversify risk
For those investing in borrowers who they don't know, it's a good idea to diversify risk by distributing funds over more than one loan.
Instead of lending $500 to $1,000 to one individual, fund a variety of individuals, Garascia suggested. That way, if one of the loans does default, all is not lost. And if investing in a higher risk borrower, consider a lower risk loan to balance it out.
4. Start small
Baltimore's advice for those who want to become lenders: "Start slow and get a feel for how things work," she said. "I haven't done a huge amount of money ... but enough that if everyone pays up, it would be a decent investment," she added.
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