Investors hungry for yield on their fixed-income portfolios are looking at every avenue to eke out a few more basis points here and there and that includes lending money to borrowers at one of the many peer-to-peer lending sites. Should you? But before that, a quick primer on what this whole deal with them is.
Traditionally, if you needed to borrow money, you went to a bank. And that’s what banks do. They collect deposits from folks like you and me and lend it out to people who need to borrow money to say, buy a car or a house or to start a business. And if there is a recurring need to borrow money, you use credit cards. In general, banks are where you traditionally go to borrow money.
But some folks are unable to borrow from a bank because the bank is unwilling to lend them the money. Either their credit history is poor or their employment situation is dicey. In general, they are not a good risk in the bank’s eyes or the bank wants to charge them too much money…more than they are willing to pay. Or they don’t want to borrow as much money as the bank is minimally demanding. The bank doesn’t want to lend you money if all you want is a few hundred bucks. It’s not worth the bank’s trouble to do that so the bank has a minimum amount you must borrow. For all these and other reasons, turning to the bank is often problematic for a lot of people. Historically there has been no answer, no solution but technology again came to the rescue in the form of peer-to-peer lending. There are hundreds of sites now that offer this service where you can post your need to borrow say $25 or $100 or $100,000…whatever it is you need to borrow. Most people are borrowing a couple of hundred bucks for usually a short period of time and they post on these sites about their need to borrow and why. If there is a borrower than there of course is a lender. You can also go to these sites and be a lender to these people and lend them as much as they are asking for. If they are looking for $5,000, you can lend them the entire amount or you can lend them 10 bucks towards the $5000 and in a crowdfunded, crowdsourced manner, lots of people offer to come up with 10 bucks a piece until the guy gets 500 of those people and he gets his 5000 dollars. He pays interest to the site and the site acts as a clearing house by collecting your money and distributing it to the guy who is borrowing it. The borrower then makes his payments to the site which redistributes the principal and interest payments back to you, the lender and they collect a fee for serving as a middleman, just like what a bank would do.
This all sounds great but we are really, really nervous about these peer-to-peer sites as a lender. No issues being a borrower on these sites though. With borrowing, there is not a lot of downside because you are the one taking other people’s money so they are the ones with risk, not you. But if you are going to be a lender, be very, very, very careful. This is a completely unregulated environment and the internet is still the wild, wild west. This industry is still evolving and there are a lot of unknowns. You really don’t know who these people are, you really don’t even know about the veracity of the site that’s being used and the risk of you not getting your money back is pretty darn high. So if you are going to do it, we would strongly encourage you not to lend a significant amount of money to any one person. Ideally, no more than 25 to 50 bucks to any single borrower and do this with as large a number of borrowers as you can to diversify. And do it with as large a number of lending sites so again you add to that diversification angle in case there is a problem with one of these sites. Also, there is an incredible lack of liquidity associated with this process. You can’t demand the money back on a moment’s notice. You are subject to the repayment terms and the willingness of the borrower to honor those terms. So we would not personally participate in these sites as a lender but as a borrower, no problem.
This is yet another illustration that disruption and technology develops very, very rapidly…much faster than the regulatory environment to catch up with it. Regulators are usually reactive and only respond to stuff that has already happened. Nobody in Congress wakes up one day and says that they have a feeling that one day, they will invent drones and hence regulations are required for the FAA on how to handle drones near the airports. That’s not how it works. They wait for the drones to fly around the airports for them to realize the need for regulations to deal with it. This peer-to-peer stuff is sort of similar and until something breaks, this will remain the wild, wild west.
And here is the biggest challenge. If you are going to follow our protocol of investing a very small amount of money per borrower and diversifying among many, many of them and if you are only going to do 25 or 50 or 100 bucks per borrower, how many borrowers do you have to lend money to to be able to deploy a sizable chunk? What if you have $10,000 to invest? Are you going to give loans to a 100 different people? And then you have to evaluate what is the blended return you are going to get from this bunch compared to the returns you might be able to get elsewhere. Is the return so much better that it is worth the effort in the first place, net of the fees and the default risk associated with these sites? To us, it is a really nifty idea for a very niche environment and that is all we have to say about it. Be really careful and as with most of these things, don’t be the first one on the block to try it. Don’t gamble more than you are willing to lose. Don’t allow the greed factor, the desire for higher returns exceed the fact that you are taking on huge and oftentimes uncompensated risks in this lending process.
You want better yields, try junk bonds instead. At least there is a viable enterprise you are lending your money to and with that investment being backed by the assets of that enterprise. The default risk is likely lower and the effort to deploy large amount of capital is relatively painless. And of course, if you do plan to invest, you would want to do it with a much smaller portion of your total portfolio because by investing in junk bonds, you are still engaging in subprime lending to companies with sketchy business prospects and lower long-term survival rates.
But with peer-to-peer lending, stay away…at least as a lender.
Image credit – Michael Galpert, Flickr