Updated on 01.29.11

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

Trent Hamm

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.

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  1. Jane says:

    You do know that more often than not Kiva has already lent the money to the person on their website and that they already know the outcome of the loan? And if the loan fully defaults, they kick in their money sometimes to give you a better result? They mostly do things the way they do, because people like yourself appreciate the personal touch and want to feel as if they are personally lending money to that women in Guatemala who makes fabric or whatever. I’m not saying that microlending isn’t incredibly valuable (it is!), but I do find the way in which Kivo does it to be misleading. It takes money to maintain that website and make people feel better about their “borrowing”. I would rather they spend that money on more loans.

    I would post links about this, but you can just goggle “Kiva misleading” and you will find tons of discussions of this practice. It is rampant in charities. Adopt a child charities have also already funded those children who sent you letters in the mail (and they might send many families personal letters just like yours – you are not their special donor). You are also not actually buying a chicken in Romania (although the Heifer International is one of the only charities that is open about this.) They’ve just found that people tend to give more if it is personal.

  2. Jules says:

    It’s interesting that you still advocate microloans. From what some people have been suggesting, they are a curse rather than a boon, especially when unscrupulous lenders target the financially illiterate poor (sound familiar?). There’s a growing body of criticism over microloans; while I’d probably still donate to international bodies that have the infrastructure for oversight, it’s not something that I’d automatically sign a check for. As it is, my donations go to Cordaid.

  3. Katie says:

    It takes money to maintain that website and make people feel better about their “borrowing”. I would rather they spend that money on more loans.

    Except that if they didn’t spend money maintaining that nice website with the personal touch, they wouldn’t have nearly as much money to spend on loans. I know there’s a tipping point on that one, but I don’t think we can criticize all publicity efforts as a matter of course.

  4. Jane says:

    True, Katie. I hadn’t thought of it that way. But I do think they insult the intelligence of donors. They could still highlight the individuals who they have helped in the past to give me a sense of the personal impact without misleading me into thinking that someone won’t get a loan if I don’t contribute in the next hour and fifteen minutes.

  5. Tahlia42 says:

    With Kiva, the maximum amount you can ever earn back on a microloan is the amount you put in. It is not designed to earn you money. It is designed to help people in need. Also, since Kiva is itself a non-profit, they have it set up so you have to opt out of donating to them with each transaction (I always donate because I believe in the work they do).

    Just because Kiva is a non-profit doesn’t mean that the companies on the ground in all these places around the world are as well. They charge interest to the recipients, which does not make it back to the Kiva donatees.

    While these comments may sound negative, they weren’t meant that way. I just wanted people to understand that it is a form of doing good and not a money maker. I fund a $25 loan a month and have for 3 years. I’ve only had 2 defaults and 5 late payers. While you can’t write it off on your tax deductions (except the donations to Kiva), it does feel good.

  6. valleycat1 says:

    If I were to get into P2P, I would consider it a donation to charity, not an investment vehicle. Kind of like helping a friend or family member who needs money-getting paid back is hoped for but not a big deal if it doesn’t happen.

  7. kjc says:

    I can’t imagine anyone would invest their “whole portfolio into such lending sites,” or any other investment product, so I don’t quite know why this point is bold faced.

    Based upon a recent post at Tynan.net, I opened an account with Lending Club, and will give it a try with a relatively modest amount (<$2K).

    And Jane, thanks for your comment. I Googled "Kiva misleading," and the articles I found were eye opening, to say the least.

  8. katie (another katie) says:

    Maybe I’m a voice of dissent, maybe not…we’ll see when more comments roll on in. I think P2P is brilliant. The banks are making a ridiculous spread on their loans compared to how much interest they are paying out on savings accounts and CDs. They are charging consumers absurd rates on credit cards.

    If you use the sites, you can spread your cash across several loans to help diversify and reduce your risk. You may end up helping someone legitimately in need. Could people game the system? Almost certainly, but there are always jerks who do nonsense like that. I’d rather loan my money (if I had more of it!) to someone else at 4-15% (or whatever) than to a large for 0.001%. The large bank may not run off with my money, but they did already run off with taxpayer’s money, and since I pay taxes…I figure they already got my cash and I’m not much interested in giving them more.

    I’m not advocating putting all your cash into P2P. Of course some of the loans will fail. But I don’t see a problem using this as another investment tool and a way to try to grow some wealth. If you’re savvy, you already know you need to be careful and won’t invest carelessly.

  9. Dave Ingram says:

    I’m glad you’ve given p2p lending another look. One thing I’d like to mention is that Kiva does not pay any interest on their loans, and they are not very straightforward about this fact unless you dig deep into the FAQs. I prematurely made a Kiva loan before realizing that I would receive my money back in about three years with no interest.

    Investors looking to get into microfinance can check out microplace.com – they offer anywhere from 1%-3% returns. It’s not much but it’s an actual investment, not just a donation to a lending institution.

  10. @ kjc I can’t imagine why people pulled all their money out of the stock market in March 2009, but it happened all over the country. People often make irrational decisions about long term investing, so hopefully disclaimers like this will make them think twice.

    re:Kiva My biggest problem with Kiva is the amount of interest generally charged. I’d be OK if it was something <10%, but basically they charge credit card rates to make up for the time and money spent managing micro-loans. I'm not comfortable spending my charity dollar to enable that, especially since I am Christian and therefor enjoined not to practice usury.

  11. Mark S says:

    I have about $2,500 at Lending club over the past 2 years and have a return of 14%. If you use their filters well and use a little common sense, it is easy to find loans they classify as “risky” which have a lower default rate than the average for that group. I have had 3 defaults on my 100+ loans.

  12. PunctuationMark says:

    I had been looking at LendingClub for a long time.

    The biggest hangup for me is that the site has yet to make a profit in its history. Their prospectus states, “We have incurred net losses in the past and expect to incur net losses in the future” and, “we may not become profitable”.

    All backup plans and collection agencies aside, I have a difficult time trusting my investment to a site that admits they may not have a financially sustainable system.

  13. Peter Renton says:

    I think people are misunderstanding the difference between microfinance (Kiva) and peer to peer lending (Lending Club and Prosper). Kiva lends out money (mainly to people in developing countries) in the hundreds of dollars and is purely non-profit, there is no return to the donor. Lending Club and Prosper lend out money in the thousands to individuals in the US.

    I have accounts with all three institutions and I have been happy with all three. I am getting a great return on my money on Lending Club and Prosper (averaging around 10% over the last 18 months). While Kiva may have some misleading practices I am happy to continue to support entrepreneurship in developing countries.

  14. I think it’s hard to compare Lending Club and Prosper (LC/P) to Kiva. LC/P is for the purpose of investing while Kiva is for the purpose of giving to charity.

    I wouldn’t give money intended for my Roth IRA to my religious organization or the Red Cross. I wouldn’t put my money intended for charity causes in the S&P 500.

    We shouldn’t conflate the two just because they are peer-to-peer.

    I look at LC/P as a way to diversify your investment portfolio. Due to newness of them, it probably doesn’t make sense to put more than 5% of your portfolio in them. The loans are essentially bonds and since the risk is spread out amongst many loans, it is not as risky as it may appear.

    It may be nice to help out someone for the social aspect of it, but it has been my experience that people often don’t read the stories when investing. They certainly don’t follow up and become friends with the people they are lending money to.

    I don’t know if I would want that kind of connection anyway. I don’t expect to talk to all the employees of all the companies in the Russell 2000 before investing there.

  15. Matt says:

    Lending Club, for me, IS solely for investing – and I do expect a decent investment return from it (and so far, that is what I’m getting). I’m not putting money into LC to “feel good”, except in as much as “feeling good” comes from making wise investing decisions, spread out over many loans, with a roughly 10% rate of return. And, as has been mentioned, the big banks did a wonderful job of not only gaming the system, but stealing from we, the taxpayers, with amazing efficiency. If LC helps cut into their business, so much the better. I’d rather take my chances with a housewife wishing to consolidate debts with my mere $25 investment, than a 2% (if I’m lucky) rate of return from Big Bank, Inc.

    Kiva is for charity, pure and simple. I don’t view it as an investment at all. Yet, while I’m quite comfortable with LC, I’m not with Kiva – and choose to use more established vehicles for my charity dollars.

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