Peer-to-Peer Lending: Power to the People

We live in an interconnected world. Phones alone have replaced watches, alarm clocks, and cameras. The internet is everywhere. The internet is incorporated into all levels of everyday life. Finally, the internet is starting to be seen in banking. Since 2005 people can choose to borrow loans from other people instead of the banks through the internet. The industry is called peer-to-peer lending.

How Peer-to-Peer Lending Makes a Profit

This opens up an opportunity for us as investors. We can use the internet to connect to interested borrowers and give them loans. Depending on the risk level of the borrower, a lender can expect returns from 4% up to around 30%. Obviously the higher risk the borrower the higher the interest rate you can expect them to pay.

How are Borrowers Rated

Borrowers are rated primarily by their credit scores and their annual income, among other things. Right now there are two large websites that allow you to invest in peer-to-peer loans: Lending Club and Prosper. A nice thing about both Lending Club and Prosper is they don’t make you pay an entire loan. Instead, you can buy $25 portions of different loans to minimize the risk of your loan defaulting.

Peer-to-Peer Lending Creates Diversification

Another great thing about peer-to-peer lending is that it is not closely tied to the stock market. This means that by investing in peer-to-peer lending in addition to stocks, you can diversify your portfolio a bit more and help mitigate risk. The loans come in 3 or 5 year increments. However, you can also buy and sell notes that are already part of the way to maturity.

Both Lending Club and Prosper put all the information on their loans online for investors to view. The loans typically have a default rate of around 5%. Since you can buy $25 portions of loans you should be able to buy into enough loans that you should be able to achieve fairly near to the 5% default rate.

Finding a Profitable Interest Rate

In order to decide whether or not investing in a note of a certain interest rate is worth the risk, it can help to take a look at something called expected value. Think of it this way: if every loan were paid off, then the expected value would be the amount invested plus the amount of interest paid. For example, if $100 were invested at 4% and the default rate was 0, then the expected value would be $100 + $4 = $104.

In an ideal world everybody pays their debts, but in reality we have to account for the default rate when calculating expected value. Here is a formula for finding what interest rate you need to earn a certain profit in the long-term. P stands for profit, i for interest rate and d for default rate. The formula is (p+2d)/(1-d) = i. Let’s look at an example of the formula in action:

I am looking at lending to borrowers with a C credit rating. This rating has a default rate of 5% and I want to make a 3% profit. I can use the formula with 3% = 0.03 for p and 5% = 0.05 for d. This gives us (0.03 + 2*(0.05))/(1-0.05) = 0.137 . This means that to realize a 3% long-term profit you would need to get at least an interest rate of 13.7% on the loan. If lending club is willing to give us 15% on such a loan then we can feel confident we will make more than 3% in the long term.

Peer-to-peer lending is probably not a replacement for traditional investing in stocks and bonds. However, it can be a great way to diversify your portfolio and earn a decent yield in today’s low interest rate economy.

 

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