NorCalSavant

Got some cash sitting in the bank in your savings or checking accounts?  Historically, you could have invested that extra cash in a CD at a bank for a little higher interest rate than that from the savings or checking account.  But now there is another option where you can get even higher returns.

With the advent of modern technology and Internet, you can lend your money at a number of peer-to-peer lending sites to borrowers.  These peer to peer lending sites bring lenders and borrowers together.  As a lender, you choose the loan you want to fund at an interest rate accounting for the borrower’s credit worthiness, for example credit score, debt ratio, etc.  The lending site services the loan, i.e. collects principal and interest every month from the borrower and deposits it into your account.

The lenders get a higher interest rate (compared to a bank deposit), and borrowers get a lower interest rate (compared to a credit card debt) making it a win-win for both the parties.  The P2P lending sites make their money by charging fees to the lender and the borrower.  A few of these P2P lending sites include Prosper, Lending Club, and Fynanz.  Of these, Prosper is currently not accepting new lenders until they complete registration process with SEC for a public debt offering. 

The interest rates on loans start typically at eight to ten percent for highly rated borrowers, and can go up to as much as twenty percent.  This compares with interest rates of around three percent for a CD, and even lower rates for plain old savings accounts.

It is very important to understand a few things here — (1) that the interest return accumulates differently, (2) there are different liquidity implications, and (3) there are risks associated with P2P lending.

Interest Rate Comparison

The interest rate on a CD cannot be compared directly to that on a loan lent through a P2P lending site – something that the lending sites conveniently ignore when comparing the interest rate on a P2P loan with that from a bank account.  Typically, on a CD the entire principal keeps earning interest to the end of period and the interest truly compounds.  On a P2P site loan, a part of the principal is returned with every installment payment.  Consequently, the interest earned every month keeps going down as time advances.  Of course, the principal portion of the payment correspondingly goes up to keep the monthly installment the same.

For example, consider putting $1000 into a CD for three years at 5%, and lending $1000 at a P2P site at an interest rate of 5% after accounting for service fees with payments spread over three years.  At the end of three years the CD investment would be worth $1,161.82 assuming daily compounding.  However, the monthly payment from the loan would be $29.97, resulting in a total return of $1,078.95 from the loan in three years.  Effectively, the interest gain from the CD was $161.82, while that from the loan was only $78.95.  If the CD interest rate were 2.5%, the CD would be worth $1,077.88 at the end of the three years, which is almost the same as $1078.95, the total return from the loan at 5% interest rate.

In other words, the comparable interest rate on the P2P loan could be considered just about half of the stated 5% rate.  However, this was just an example to clarify the real return comparison between a CD investment and P2P lending.  In real life the interest rates on a CD and a P2P loan are not the same.  A 15% P2P loan might be comparable to a CD when the CD interest rate jumps up to 7.5%.  If that happens, most likely the P2P loan rates will go up too.

A strategy to maximize the return from a P2P loan is to diligently transfer the loan installments to a savings account to earn additional interest and effectively raise the total returns from the loan.

Liquidity

Another major difference between a savings account, CD investment and a P2P loan is in the liquidity of the funds.  A savings account is completely liquid meaning you could withdraw your money as and when needed, unless the bank folded – more on the risk later.  A CD investment is not available for the duration of the CD, unless you are willing to pay a penalty.  The outstanding installment payments from a P2P loan are not available before the time.  Paying an early withdrawal penalty is not an option.

Lending Club has just made it possible for a lender to offer their Notes (issued by Lending Club to correspond to specific borrower loans) for sale prior to maturity on its trading platform, allowing the lender a measure of liquidity.  Prosper also seems to be working to start a resale facility at a future date.

Another option in case you need the money prior to maturity is to borrow the same amount of money from other lenders at the P2P site.  Your incoming payments from the lent loan could be used towards the outgoing payments for the borrowed loan.  If you have good credit standing, which you probably should because you are able to lend, you would probably pay a lower interest rate on your borrowed loan than you would get on your lent loan.  It probably gives you an idea for arbitrage – borrow low, lend high, use no personal capital.  But arbitrage is only when there is no risk.  Here, there is a clear risk of default by other parties.

Risk

That brings me to the most important consideration of risk.  A savings account or a CD is federally insured to $100,000 ($250,000 for now) or other appropriate amounts.  There is no risk of losing any part of it.  Lending on a P2P site carries no such insurance.  If the borrower defaults, a collection agency may or may not be able to get some of your money back.  The borrower pays a price in terms of his or her future credit, but you could be out of your money.

You could better manage your risk by choosing borrowers matching your risk criteria and by spreading your capital to many loans.  There is no free lunch as they say – higher the return, higher the risk.

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