Some Deeper Thoughts on Peer-to-Peer (P2P) Lending

A few weeks ago, I gave a somewhat negative opinion of P2P lending sites such as Lending Club and Prosper. Here’s what I said about them:

Quite honestly, if I were going to invest my nickels and dimes into peer-to-peer lending, I’d probably do it with Kiva and not worry that much about a return.

From what I’ve seen, on such peer-to-peer sites, the returns on the few good loans they offer are really low, while the failure rate on the higher risk loans are so high that you’re going to have a challenge making a good return through all that noise. From my eyes, it becomes akin to gambling at that point, since you really have limited information on who or what you’re investing in.

If you like the idea socially and conceptually, go ahead and use them, but view it as a very speculative part of your portfolio.

Since then, I’ve received a deluge of emails from readers who have experienced different flavors of success with peer-to-peer lending, and these emails have encourged me to re-evaluate my response a little bit.

Let’s back up. P2P lending means that a website or organization, such as Lending Club or Prosper or Kiva, facilitates an arrangement where you directly lend money to another person who needs money. They do a lot of the footwork for you in terms of evaluating the risk of that person, but you’re the one that puts the money forward.

First of all, I will say that in terms of dollars and cents, I would not invest my whole portfolio into such lending sites. They are unquestionably risky and you simply don’t have the loan support structure that lending companies have. While the sites, by all accounts, do a good job of keeping the sharks out of the water, it still doesn’t stop a specific individual from deciding not to pay the debt back, much like some people charge their credit card to the limit and walk away from it.

Investments such as these inherently come with significant risk. Most people are honest. Some people are not. In the end, what you’re really betting on is that another person, given a debt repayment structure, will repay that debt. Most of the time, that will happen. Some of the time, it won’t.

Any good portfolio will not have all of their money in one single risky investment. Even those heavy on risk will typically have their money spread across different types of risk (the exception being someone who intimately knows every detail of a specific investment, like someone going heavy on a specific stock because they know the company).

Second, generally the lower risk investments on such sites have a lower rate of return and the higher risk investments have a higher rate of return. Such investments have a pretty clear balance of risk and reward. If you’re seeking a lower risk investment, you’re going to have to settle for a lower rate of return. The same is true for high risk and high return. There isn’t much to exploit here – you can’t get a high rate of return for low risk. That’s due to the evaluation that such lending sites put potential borrowers through.

The biggest reason that many people invest is not the return, but the sense that this type of investment is a socially beneficial thing. Rather than making money off of large corporations or governments, such loans help out individual people – the little guy. For many, this is an enormous social benefit that outweighs some of the uncertainty of the investment.

This, in fact, is the big reason I tend to encourage people to try Kiva, which encourages microlending to potential entrepreneurs in highly impoverished places, rather than loaning $500 to someone who just totaled their car. This is more a reflection of my own perspective, which is an acceptance that a global economy is simply a fact and the greatest good for both preserving an American standard of living is to raise the global standard of living as quickly as possible.

In short, there are a lot of good things about peer-to-peer lending. The weakest aspect of it comes purely from the perspective of “dollars in, dollars out,” where you could argue that it’s not the best investment opportunity in the world. However, it does offer social benefits that go far beyond the simple dollars and cents.

Trent Hamm
Trent Hamm
Founder of The Simple Dollar

Trent Hamm founded The Simple Dollar in 2006 after developing innovative financial strategies to get out of debt. Since then, he’s written three books (published by Simon & Schuster and Financial Times Press), contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.

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