There has been a good deal of hype recently from various financial media outlets regarding peer-to-peer lending. The allure for the investor – big fat yields upwards of 8%, 10% or even 15%! In an era when banks pay virtually nothing for deposits, this sounds too good to be true. When faced with an opportunity that sounds too good to be true, one must always dig deeper to determine whether or not it is a prudent option. As a logical starting point for this discussion, let’s review how Peer-to-Peer (P2P) lending works. P2P lending sites allow borrowers to connect directly with pools of smaller lenders. For example: Person A may want to borrow $10,000 to pay off high-interest rate credit card debt. Persons B, C, D and E review person A’s information through a P2P site (debt-to-income ratio, FICO credit score, loan term, interest rate, number of recent credit applications), and decide whether or not to lend them a portion of their desired loan. Persons B, C, and D may elect to loan a given amount to A, while person E might pass on that particular borrower based on some criteria. The model seems simple enough – investors spread their funds out amongst multiple loans to mitigate risk while earning a hefty return. This seems particularly attractive in the current environment, one of persistently low interest rates. Investors must be very careful, though, as an unquenchable thirst for yield can lead to taking on too much risk. Risk, in fact, is the primary downside of the outsized yields. The high yields offered by P2P lending sites should be seen as a red flag and reason to investigate further. What are the risks of investing in P2P loans?
- You are lending money to strangers with spotty credit histories
- People applying for loans on these sites have likely sought to borrow funds from another source and been turned down. They then end up on P2P lending sites because no one else would lend to them. Do you want to lend to these people?
- Most P2P loans will not generate productive assets
- Many of these loans are to pay off credit card debt or undertake some small project, such as building a swimming pool. The money lent rarely goes towards creating or increasing any cash flow.
- P2P loans are unsecured
- Unsecured P2P loans provide very few legal rights of recourse for lenders. If the debtor does not pay, the creditor has no way to recover losses as the loans are not backed by collateral. This is in contrast to corporate bonds. Corporate bonds have indentures with positive/negative covenants restricting the actions of the borrower and a clearly defined debt hierarchy which details which creditors are paid off first. In the event of a corporate bankruptcy there are relatively predictable recovery rates, while in a P2P default, the lender is unlikely to recover any of their original investment that had not been recouped in payments to that point.
- It is very difficult to get your money back before a P2P loan matures. There is a very limited secondary market, but this would likely not be an option due to steep discounting.
- Diversification may not provide expected benefits in major market events
- With such low credit quality, and no legal recourse in default, diversification may fail just when it is needed most, such as in a major credit crisis or recessionary event.
- Credit analysis falls on the lender
- The lender, in this case, may have little to no experience in evaluating the creditworthiness of a borrower.
Many of the media advertisements for these P2P sites compare the “attractive” yields to savings accounts and treasury bonds, citing historically low rates in the .1% – 1.0% range to make them seem attractive. This is hardly comparing apples to apples though. With the risks stated above, P2P lending is far riskier than savings accounts. A quick glance at market interest rates and how things have progressed since the great recession may put this in perspective. Five-year Treasury’s currently yield 0.9%, while U.S. high-yield (“junk”) bonds with a duration of four years have yields of approximately 7.25% (data as of mid-2014). Three-year loans rated B1 by Lending Club (a leading P2P site) pay an average of 10% interest before fees and defaults. After fees and defaults, Lending Club claims the number comes out to about 8%. It would appear that a much more appropriate benchmark by which to evaluate the prospects of P2P lending would be high-yield junk bonds. Lending Club claims its loans issued in 2007 (maturity of roughly 3 years) had an average return of 3% (after fees and defaults), and that its loans in aggregate have never lost money. In comparison to an appropriate benchmark, the Vanguard Corporate High-Yield Bond Fund (index fund for the U.S. junk bond market) returned about 12% from 2007-2009. Return alone cannot be the sole factor in determining an investment. Risk-adjusted return is a vital consideration. It does not appear that P2P loans provide adequate return to compensate for their risks, which are well beyond even lower quality junk corporate bonds. So, as for the question, is P2P lending a good idea for the average investor? It depends. These loans are by no means for short-term or low-risk money. Most experts would advise that rather than a key source of income, these loans represent a tiny sliver of an otherwise safe bond portfolio.