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Hello dear grasshopper! Wouldn’t it be nice if someone were to just reach their arm right out of your computer and drop a nice bag of gold coins on your lap? And nicer yet if they did so on a monthly basis, each and every month handing you more and more bits of silver or gold or your favorite currency?

But of course, this being Kung Fu Finance and not “slack-off-and-wish-someone-would-hand-you-money-for-nothing-all-day-finance”, 🙂 (although it is fun to daydream), I can’t promise you quite what the picture does.

But I think I can actually come close, thanks to a relatively new type of investment called peer-to-peer lending.

If you are anything like me, and like most individual investors right now, you are probably searching desperately for yield in that struggling “income” section of your portfolio.

U.S. Treasury bonds?

Not when the 10-year note is paying 1.72% and the 30-year bond is paying a paltry 2.82% (be still my beating heart…so after inflation I have to pay my government to lend them money? No, thank you!)

CD’s and savings accounts?

Don’t make me laugh…(or rather cry, as the case may be!)

Dividend-paying stocks?

Perhaps, but along with carrying more risk they are not exactly cheap right now…

REITs? MLPs? Rental real estate?

Possible, but all require much more research and in the case of rental real estate, footwork (unless you have a wonderful agent and property manager already lined up!)

But happily, a few weeks ago I received an interesting guest post idea from a long-time Kung Fu Finance reader, Larry Ludwig, who wanted to write an article on a relatively new alternative to the above…peer-to-peer investing (also not without its risks, but Larry gives a great rundown of it in his posting today!).

And as it turns out, Larry has extensive boots on the ground experience with this— he has had a portfolio with LendingClub for several years, and has just opened one with Prosper.

Today, Larry will share with us his personal experience with peer-to-peer lending and you can see if it’s something you’d like to add to your own portfolio!

It’s certainly an interesting alternative to some of our other income options at the moment, and it doesn’t require much capital to get started.

Take it away, Larry!

Peer-to-Peer Investing – A Viable Fixed Income Option?

With the Federal Funds rate set from 0.0% – 0.25% until at least 2014, your options for fixed income investing are pretty limited. Bank CDs are now earning less than the average rate of inflation. The trailing twelve months’ of inflation has been 2.8%. Yet according to Bankrate.com, the highest five year CD only earns 1.85% APY. That’s not the average rate, but the highest rate offered.

This means you are losing money in terms of real dollars, and your purchasing power is eroding. As a retiree or someone looking for steady income, what are you to do? Your traditional investing options are pretty limited.

What is Peer-to-Peer Investing?

Fortunately, a new investment class has come onto the scene. The risk profile is similar to junk bonds, but with much more control of risk. Peer-to-peer investing (otherwise known as P2P investing) allows you to effectively become a bank, while also bypassing the traditional banking system.

Banks have been doing this for years. They charge high annual fees on credit cards and make a huge profit in the process.

However, the only way you could take advantage of this as an individual investor used to be by investing in the credit card companies, or in the banks themselves. As you can see, this is not a very direct method to profit from consumer lending. The companies typically offer other banking products as well, which dilutes any profits from unsecured credit.

So it’s best to invest directly. The two most popular P2P companies in the United States are Lending Club and Prosper. As an investor, you can use either company to purchase notes of individuals wishing to borrow money.

Instead of a bank funding the loan, you and a pool of other investors each typically invest $25.

P2P Investing Benefits Both Parties

The Credit CARD Act of 2009 caused the unintended consequence increasing credit card interest rates. So if you have any credit card debt, it’s not uncommon to pay 15% or higher in credit card fees.

However, interest rates for P2P lending start as low as 6%, thus saving the borrower thousands in interest expenses.

The peer-to-peer investor also makes out in the deal. Compared to the typical 2-3% fixed income returns investors are seeing, P2P investors typically receive 8-10% returns.

For the over three years I have been investing in Lending Club notes, I have earned over 9% ROI.

Where is it possible to find that type of return in fixed income today?

How Can You Minimize Risk?

However, investing in peer-to-peer lending is not without its risks:

  1. Notes are not FDIC insured, and it is possible that a borrower could default.
  2. Just like credit cards, the loans are unsecured and are not tied to any asset.

So, to minimize the risk of a note defaulting, you invest in many notes — a lot of them!

With my $10,000 portfolio with Lending Club, I currently have over 500 active notes, but only have 12 defaults.

With a small pool of invested notes, one default can be devastating. But by diversifying with a large pool of loans, a few defaults will not affect your return dramatically. This is no different from what banks do—the more notes you invest in, the more stable your return becomes.

Additionally, you as an investor can pick and choose the notes you invest in, which allows you to manage the risk.

If you don’t like borrower’s profile, you can skip it and move on to the next one. You can also choose the risk level of your investment pool. The higher the rate of return on the note, obviously the higher the chance of default.

What I have done to minimize defaults is to look at the historical data. Both companies are very transparent with their loan data. They give out data feeds, so you can analyze the loan history. If you are proficient with a spreadsheet, you can do it yourself. There are also web sites like Lendstats.com (unfortunately via a crude interface) that allow you to dissect the data so you can find the best returns.

Why Did I Pick Lending Club Initially?

I’ve been an investor of Lending Club for over three years now. I also reviewed Prosper, and recently opened an account with them as well.

When I first researched both companies back in 2008, Proper’s lending model was much different at the time. Their risk profile for the borrowers was minimal, and the investor returns showed this. Pretty much anyone with a pulse was allowed into Prosper’s lending system. The returns for many investors was poor, or in some cases negative.

Lending Club on the other hand had a much more effective risk-to-default rating process. Banks for years have done credit risk models, and understand the likelihood of whether or not a borrower will default. Lending Club’s risk model was much more in tune with the way banks score risk to default. Therefore, I chose Lending Club for this reason.

In July 2009, Prosper completely changed their underwriting process, and is now very similar to Lending Club. After studying historical returns from this period forward, I decided to open an account with them as well.

What Are The Expected Returns?

My experience with Lending Club has been great so far. With over 9% ROI it’s hard to find another fixed income investment that beats it.

While my return has varied slightly over the years (1-2% range), it’s been relatively stable. Obviously your own returns can differ, but my returns are pretty typical based upon anecdotal research and on the statistics released from the P2P companies. With my Prosper investment it is still too early to determine the returns, but I expect a very similar outcome.

Do I Recommend P2P Investing?

Without question yes! While I do not suggest putting a large percentage of your net worth into P2P, it can be used to juice up your fixed income asset allocation. It is a long-term investment.

While it is possible to sell notes on the secondary market, notes are not very liquid compared to other fixed income investments. This therefore makes P2P investing not a wise choice for your short-term (under 3 years) investments. Investing is slow in (because of the time it takes to find qualified borrowers), and slow out (because of the time it takes for borrowers to completely pay back the note).

Peer-to-peer investing is still a relatively new investment class, but definitely shows some promise. It’s similar to the asset class of junk bonds, but with much more control with only a small amount invested.

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This was a guest post from Larry Ludwig of Investor Junkie. Larry writes about how to become a better investor and entrepreneur.

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Thank you, Larry! Something to consider, for sure…9% is pretty darn good, although I imagine it does take time to find a portfolio of 500 or so qualified borrowers.

Has anyone else had experience with peer-to-peer lending you’d like to share? Please let us know in the comments—I’d love to hear what you think about this idea!

To your financial success,

— Kung Fu Girl