The following is the eighth of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered foreign currencies. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
Some believed that peer-to-peer lending was just another here-today-gone-tomorrow Internet "thing". But after the Lending Club’s IPO hit $1 billion late last year, the truth became clear to just about everyone -- there is a new lending sheriff in town.
"Peer-to-peer lending has nothing magic, it’s simply being more efficient in the lending process by replacing banks with Internet-based marketplaces. But doing so brings very attractive returns for investors. Historically, platforms like Lending Club return about 7% net per year, with very low volatility. Automation tools like LendingRobot even allow investors to reach 20% net turns, still at very low risk," says Emmanuel Marot, CEO of LendingRobot.com, which enables individuals to access automated trading algorithms and portfolio management capabilities for participating peer lending marketplaces.
Even institutional investors have gotten in on the game. "In a world with interest rates still at historic lows, and likely to remain so for quite some time, it’s no wonder that this space is becoming very popular to institutional investors like us who make sizable investments given the larger pools of capital we deploy. But there is still room for the retail investor to open an account and start generating a healthy return relatively quickly and they can make bite-size investments in loans as little as $25 per loan in many cases," says Nicole Rothschild, CEO and CFO of Petra Partners.
There’s much to like. There is transparency of choice. Lenders choose which borrowers get their money. You can choose to help fund someone’s college education, a wedding, house down payment, business, movie project, pretty much anything. Typically an abundance of data is available about every loan. The platforms also perform much of the work pursuant to loan origination, like vetting the borrowers, eliminating fraud, setting loan terms, and the like, says Rothschild.
The peer-to-peer lending sector keeps morphing. Funding Circle recently became the first major peer-to-peer lender in the U.S. to offer individual investors the opportunity to invest in secured small business loans with the launch of its new Fractional Loan Marketplace. Investors can buy fractional pieces of secured small business loans ranging in size from $25,000-$500,000, and in terms from one to five years, with coupon rates of 5.99-20.99%. "There is tremendous demand for fast and affordable small business loans; we’re about to cross $1 billion in originations globally," said Sam Hodges, Funding Circle’s co-founder and U.S. managing director, during the announcement of the new marketplace.
For all the profit potential peer-to-peer lending can possess, it’s no panacea. "P2P investing is easy, you open an account, deposit your money and you’re off and running. I love the returns you can get, but early defaults can be disheartening. It’s hard to tough it out when you lose money in the first two months," says James Lewis, who had a rough start as an investor. "There are no guarantees. For the average person, you don’t want to put a large portion of your portfolio in P2P investments."
Like with any investment, strategy is required.
Do your research
While Lending Club, Prosper and a few others are household names, there are a lot of new players. Know who you’re partnering with. Go with an established and respected originator. Hodges advises investors to look for a platform that is well capitalized with clear and transparent underwriting procedures, experience and proper infrastructure around servicing. Ask questions and read the fine print. Also know who is servicing the loans.
Understand the terms and conditions of becoming a borrower or a lender on the platform you’re considering. "Lending Club, for example, has set minimum income levels for lenders before they can lend money to borrowers. This is calculated based on the state in which the lender resides," says Kim Wales, founder and CEO of Wales Capital and CrowdBureau.
Your homework also includes a bit of investigating of who you’ll be backing. "Know your borrowers financial profile," says Kurt Westfield, managing director of WC Equity Group.
Truth is, borrowers with blemished credit histories may be able to secure a loan more easily, cautions Wales.
Understand the risks
"Loans results in a binary outcome – the borrower will either pay back the loan or not, so it’s important to choose wisely or you can lose your investment," says Rothschild. There’s also limited liquidity. After having invested in a loan, you must wait for it to perform to start seeing capital.
Know what the investment is secured by. "Whether it’s a credit score, business assets, or just reputation, you should understand what the potential security on your investment will be," says Sean De Clercq, CEO of Kickfurther.
"Diversification is by far the most important consideration. Consumer loans do not have any collateral, so the only way to reduce risks is to invest as little as possible in as many loans as possible," says Marot. Having one default out of 100 notes is different than from one in five.
Automate your investing
Hodges offers a good way to save hours of wading through hundreds of loans each week. Work with a platform that has an auto-bid function. Based on your investment goals and risk tolerance all you have to do is set your investment criteria, such as preferred rate, term, risk level, and set it and forget it.
How are your proceeds taxed? In general, says De Clercq, proceeds are considered marginal income, but certain investments qualify for preferential tax treatment, he says. "Peer-to-peer lending tends to be taxed at marginal income rates, whereas stocks held for over a year can qualify for long term capital gains tax rates."
Individuals with self-directed retirement accounts may include unsecured loans in their IRAs. "This is a great way to help someone out and build tax-advantaged income through a self-directed retirement account," says Jaime Raskulinecz, founder and CEO of Next Generation Trust Services.
Think long term
"Be a patient investor and manage your expectation, which is to say, establish your own risk/return profile and stick to it. By doing so, you’ll be far more likely to achieve your goals and far less surprised by unintended consequences," says Rothschild.
Lewis says having a long-term mindset keeps him in the game. "There may be some bumps in the short-term, but I know that I can recover if I look at the returns over a longer period of time and good diversification."
Editor's Note: To learn more about peer-to-peer investing and the main p2p companies, please refer to the DepositAccounts.com articles: Peer-to-Peer Lending: Lending Club vs. Prosper, Lending Club: A Look Back and Forward and What's Next for the Peer-to-Peer Lending Industry?.