P2P (Person to Person) loans are quickly becoming the popular new kid on the investing block. P2P lending sites such as Lending Club and Prosper allow you to loan your money directly to other people. The theory is that by cutting out the banks, both the investor and the borrower win, with lower rates for the borrower and higher rates for the lender. Lately P2P loans have gained attention with fairly steady higher-than-average returns. But are P2P loans safe?
The Risk is in the Default
Obviously, the biggest risk of a P2P loan is that the borrower ‘defaults’ and doesn’t pay you back. P2P loans are almost exclusively unsecured- meaning there is no collateral backing the loan. Although many of the P2P lending sites will take ‘collection action’ (how’s that for a euphemism) on your behalf, they also pass the costs of that collection action on to you, up to the entire value of the loan. Which means that there is at least a deterrent to borrowers defaulting, but it may still cost you the entire value of the loan, even if the money is eventually recovered.
Diversification Yields Stability
As with any investment, the more you diversify, the more stable your overall investment portfolio becomes. By spreading your investment around, your portfolio is less vulnerable to large swings from one or two investments. P2P lending sites help you diversify your lending by spreading your investment around to multiple borrowers. Lending Club, for example, by default spreads your investment between 100 borrowers. This way your portfolio is less likely to experience a massive drop from a single borrower defaulting. This diversification has certainly worked. Lately diversified P2P portfolios have yielded a pretty consistent 5-9% and lending club claims that 99.8 percent of its investors have not lost money. Certainly appealing.
But Are P2P Loans Safe?
Just because diversification makes P2P loans stable, doesn’t mean that it makes P2P loans safe. Even the 99.8 positive return doesn’t mean this is a safe investment! True, P2P loans seem to be a very juicy CD. However, P2P loans have only gained popularity recently, so we really haven’t seen how they’ll perform during a market downturn. Although Lending Club and Prosper were started in 2006 and 2005, before the ‘Great Recession’, the majority of their users have only signed up in the past few years. So that 99.8 return is skewed by loans made during a solid lending economy when default rates are at historic lows.
When the economy sours, people start losing their jobs or having their wages cut. More borrowers will default on their debt simply because there isn’t enough money to make the payments. When default rates start rising, diversification will not keep your portfolio safe. Diversification will just ensure that your portfolio’s default rates stays in line with the national average.
What nobody really knows is how default rates P2P loans will compare with default rates for other debt during a downturn. Perhaps it will be similar. Or perhaps borrowers will assume that they will be able to get away with defaulting on P2P loans. Or perhaps the low interest rates (for borrowers) on P2P loans will mean that they keep paying their P2P loans longer than their higher interest debt.
Wade In At Your Own Risk
Are P2P loans safe? Not entirely. But does that make them bad investments? Not necessarily. They are by no means the low risk, high return investment that many people claim they are. Such an investment would indeed be too good to be true. My guess is that they will end up falling somewhere between typical bonds and stocks on the risk spectrum. Over the long haul you’ll most likely show a decent positive return. Depending on your circumstances and your financial goals, P2P loans may be a good investment to complement the rest of your portfolio. Just don’t use them as a high yield 100% safe CD.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.