Does Social Lending Offer Good Investments?

by Thursday Bram · 7 comments

Social lending (also known as person-to-person or peer-to-peer lending) offer individuals the opportunity to borrow and lend money in significantly smaller amounts than a bank would deal in, as well as a social context in which to lend money. In a way, if you use one of the sites offering social lending, you can compare it to lending money over Facebook or Twitter — you can see a lot of information about the lender that a bank or other lending institution would consider less important than the statistical factors that give odds on whether or not a borrower will repay a loan.

All of this contributes to creating social lending marketplaces in which anyone — you, me or the guy down the street — can lend money and, in turn, earn interest and have the loan repaid. The big question is whether the investments are a good choice for an individual looking to earn money. On Prosper, for instance, lenders are promised returns of between 6 and 16 percent. Other social lending marketplaces include Virgin Money, The Lending Club, and People Capital.

The Risk of Social Lending

On the most basic level, it is important to remember that social loans are not like the other investments in your portfolio. They are not FDIC-insured, you can’t get advice from a broker and you’ll be facing risk. It’s not at all out of the question for a lender to default and fail to repay the loan in part or in whole.

That said, overall repayment rates on loans made through social lending sites are very good: while the historical default rates on such loans only stretch back a few years, they are still significantly lower than credit card or mortgage default rates. Most social lending take steps to reduce the risk, as well. On Prosper, borrowers are required to have a credit score of more than 640 — not the greatest score in the world, but more than high enough to demonstrate that most of the borrowers have a good habit of repaying loans.

Most social lending sites rank loans so that you can easily see which are considered riskier. Over on Lending Club, A1-rated loans earn interest rates of 6.39 percent, while D5-rated loans (the riskiest loans they offer) earn 16.07 percent. While that 16 percent interest rate can be very tempting, you can only earn it by accepting the risk that you may actually winding up losing your entire investment. Most social lending marketplaces allow you to build portfolios of loans, so that you can balance risk and earnings.

The Cost of Lending

One of the biggest benefits of using social lending as a way to invest your money is that you can do so at a lower cost. First of all, because social lending marketplaces simply connect borrowers and lenders, they have far lower costs to do business than a bank might. Fees are kept very low, meaning that more money actually goes to the loan, rather than administrative costs. Administrative costs are also reduced by the length of the loan: Prosper deals in loans that will be repaid over the course of three years, while most traditional lending institutions have to administrate loans with longer life spans (up to 30 years or more, if they’re dealing with mortgages). It isn’t unheard of for a borrower to repay loans even faster — a lender shouldn’t expect quick repayment, but when you’re dealing with small amounts, such as those necessary to jump-start a new business, the borrower can easily wind up in a position where repaying a loan in a matter of months is possible.

It’s also cheaper from an investor’s standpoint: making an investment through a broker can be an expensive prospect, if only because most investors are expected to invest significant sums of money at a time. With sites like Prosper, you can invest in $25 increments — you don’t have to have $1,000 that you don’t need for anything else. That makes becoming an investor a far cheaper prospect. You’re not going to make as much money off of a $25 investment as a $1,000 investment, of course, but you’ll still make more than having it sit in a savings account.

Non-Profit Lending

It’s important to note that some social lending marketplaces do not pay interest to lenders: Kiva, for instance, uses the interest it charges borrowers to cover the operating expenses of the site. Kiva focuses on very specific loans, made to individuals or businesses that need financial help to change their lives. Not just any entrepreneur can request a loan through the site, either. These sites treat their loans as a non-profit enterprise. They can be very beneficial to the borrowers (and can be appealing to lenders, as well), but should not be considered investments.

There are also a few sites that bill themselves as social lending sites, such as GreenNote, which are effectively geared more towards fundraising than borrowing money. While GreenNote does offer students ways to borrow money, its key function is to help students raise money in the form of charitable donations.

A Diversified Portfolio

The rates on loans made through social lending marketplaces make them well worth considering for investors, especially if you’re at a place where you want to invest but you aren’t in a financial position to invest large sums of money. However, like all investments, it is important to remember that there is risk associated with each loan you make. You must be in a position where you’re comfortable with that risk.

You can study social loans and improve your ability to earn from a loan, just as you can study the stock market. But there is far less information about social lending opportunities available, making it important to consider each investment from the start. With those considerations in place, however, social lending can offer you a very respectable return on your money.

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  • Joshua Bowman says:

    Lending Club goes up to G-rated loans at 20+%. I have a few.

  • James says:

    Social lending can be a good thing but in my experience lending money to friends you need to be very confident that you will get your money back.

    the best way to do this is to set a time frame and be very clear why they need a loan.

    just like a banker would, don’t be afraid to ask the difficult questions in order to feel confident this is a smart person to lend money to.

  • CreditShout says:

    I am also open to this possibility, as long as the lender is responsible and has a long history. It’s just another option that people should consider when borrowing money.

  • Bankruptcy Ben says:

    I’m open to the possibility of this being a good investment. I’m sure I can get a hire than bond rate and a borrower can get a lower than market interest rate it would be a win win right?

  • Yo Prinzel says:

    I really, really, really want to say yes. But no is a better answers. Social lending is not like buying a stock–there is no intrinsic value in the “position”, it’s illiquid and it’s a fixed investment. I’d liken it to investing in a bond but without safety nets beyond those set up by good intentions. But again, these loans don’t even have the liquidity of a bond, they are sometimes loaned to people who can’t get a conventional loan (And shouldn’t we be asking why?), and investors are also exposed to interest rate and other risks. Also, bonds can offer put options in the event of death–I doubt these loans do.

    If a client asked me about further diversifying their portfolio with these types of “investments” I would strongly advise them not to. Strictly from a financial point of view.

    From a personal point of view, these loans can really help individuals, which is an awesome thing in itself–but it not something to bank your retirement on. You can make a little bit of interest or feel really good about yourself when you make the loans, but if you are an investor with just a small amount of money, you’d be much, much, much better served with an IRA and a mutual fund. The risks are lower, potential returns greater, and liquidity much more… liquid.

    • MoneyNing says:

      I don’t know about every social lending platform out there, but Lending Club for instance lets you sell your loans to a third party. Statistics have shown that if you mark your prices to be the outstanding value or less, it sells in 3-4 business days which is pretty liquid, and definitely much more liquid than buying an individual bond.

      As to risks, it’s up for argument of course. A loan can go sour really quickly, but a stock can tank like no other too, even if they are solid, blue chip investments.

  • MoneyNing says:

    As a social lender, I want to let everyone know that it’s just another type of investments. There are merits on the potential, but like any investment, knowledge is key to success.

    Just as you shouldn’t invest in stocks unless you’ve done enough research on the company, you need to have sufficient knowledge about social lending before you start.

    There’s a reason why big banks lend money based on statistical models instead of using a more subjective approach. It works.

    With social lending, you HAVE to divide your loans up as much as possible and just accept the average based on your loan profile. Otherwise, you are setting yourself up for failure with any one default wiping out your returns (and possibly your principal).

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