4 Things to Know About Peer Lending

Note: This is the first in a four-part series called “Beating the Banks.” Look for more coming soon!

If you open a Bank of America savings account today and deposit $5,000, how much interest will you earn in a year?

1. Around $10
2. Around $5
3. Around $2.50

If you guessed No. 3, you’re right.  B of A is offering an interest rate of just 0.05 percent. According to MoneyRates.com’s quarterly survey, the national average for savings is 0.217 percent, and the best you can do is just 1 percent – not nearly enough to keep up with inflation.

Solution? Cut out the middleman and do what the bank does: lend your money directly to borrowers. It’s called peer lending. You join a site like Lending Club or Prosper, then start making loans and collecting interest. They find the borrowers, prescreen them for risk and do the paperwork – you decide your loan criteria, who to lend to, and how much to lend.

In the video below, Money Talks News founder Stacy Johnson talks with someone who’s been earning more than 13 percent for years with peer lending. Check it out, then read on for more…

The guy Stacy interviewed was earning a 13.26 percent return on his investment, and he’s lost no money to default since he started peer lending in 2009. But that doesn’t mean losses can’t occur, and unlike the major national banks, you’re not too big to fail. So before you commit any money, here are four things you need to know…

1. Nothing is insured or guaranteed. Unlike the money in your savings account, these investments are not backed by the government – or anybody else. Theoretically, you could lose it all. Even if a delinquent borrower eventually pays up through a collections process, don’t expect to get the full amount you’re owed. From Lending Club’s prospectus:  “If collection action must be taken in respect of a member loan, we or the collection agency may charge a collection fee of between 30 percent and 35 percent of any amounts that are obtained. These fees will correspondingly reduce the amounts of any payments you receive.” The fees listed in Prosper’s prospectus are lower: 17 to 30 percent.
2. Default rates. Fortunately, borrowers don’t default all that often, because peer lending companies like Prosper and Lending Club screen applicants for their creditworthiness. Prosper requires a credit score of 640 (calculated through Experian) and may allow loan requests up to $25,000 based on the number. Lending Club only accepts applicants with “good” or “excellent” credit, and the “good” range starts at a FICO score of 660. Elsewhere on the site, they say they “approve fewer than 10 percent of loan applications.”
3. Flexible risk and reward. Loan requests are graded based on credit risk and have corresponding interest rates. At Lending Club, average borrower rates for “A-Grade” loans are 7.39 percent, while riskier “G-Grade” loans can return 23.48 percent. Meanwhile, Prosper lists its ratings “AA” through “HR” and makes its best guess at the average loss rate for each rating based on historical data. As Stacy mentioned in the video, you can reduce your risk by spreading your money across several loans at the risk levels you’re comfortable with – and, of course, by paying attention to the applicants. The guy Stacy interviewed in the story above only lends $25 to any given borrower.
4. Eligibility. Currently, Lending Club and Prosper only allow investors from 27 states, and you generally have to make at least $70,000 a year plus meet other state-specific requirements. You can see the list and other requirements online.

Bottom line? Peer lending can easily outperform savings accounts, and maybe even stocks. But as with any alternative investment, you need to understand what you’re doing. Learn before you lend. This investment model’s only been around for a few years, as both companies’ prospectuses warn in their “Risks” sections.

We’ll be covering other investments that beat banks over the next week, but in the meantime, we want to hear from you: How do you keep ahead of inflation and save for retirement? Share on our Facebook page. If you’re new to investing, check out Ask Stacy: How Do I Get Started Investing?