- Posted by NateKragness on September 28, 2009
Peer-to-peer lending describes the practice of extending small micro-loans to your peers. In other words, you get to be the bank, which means earning a healthy return on your money while helping someone with a financial need. By extending loans directly to your peers, you have the opportunity to make a difference in someone's financial life, and you earn a high interest rate on your loans. Talk about a win-win situation! Here's how it works:
John, a borrower, wants a loan of $3,000 so that he can consolidate his credit card balances, which cost him an average of 29% annual interest. He has a stable job but poor credit, so he sets the interest rate that he will accept at 22%, which will still save him money. After reviewing his loan scenario, credit report and income documentation, you decide that making a loan to John would be a prudent and equitable financial decision. However, if you fund the entire loan balance, you put a lot of capital at risk for default. Instead, you pool your money together with 29 other investors, and the thirty of you each extend a $100 micro-loan to John. And this is the power of peer-to-peer lending: instead of funding a single loan, and risking default, you are able to spread your money across a diverse portfolio of loans, enabling you to make money in spite of the inevitable default of some of your loans.
So, just how many loans will default? Suppose you have thirty loans of $100 each, at an average of 22% interest. Statistically, about eight of these loans will default, leaving twenty-two that will be paid at an average rate of 22% interest. Since your portfolio is comprised of micro-loans, even if eight default, the high interest rates on the remaining loans will still manage to earn you a total return of over 13% on your investment. That's a great rate compared to what a bank will give you for a Certificate of Deposit (CD), and the risk is heavily mitigated by spreading your investment out over many different loans.
For those looking for a low-maintenance investment vehicle, Prosper even has portfolio plans that bids on loans for you based on pre-defined criteria. I have been using their "aggressive" plan for about 15 months now, and even after having a few loans default, I still have an annualized return of over 15%. Probably the best part about Prosper is that I don't spend any time personally reviewing the loans I fund; the process is completely automated. I even have an automatic transfer set up to regularly deposit money from my bank into Prosper; this money, along with my regular interest payments from all my loans, gets automatically re-invested into more loans. This means my money is aggressively compounding every day, at over fifteen percent interest, with absolutely no effort on my part! That's nearly five times what a bank would pay me on a Certificate of Deposit.
Keep in mind that, like a CD from the bank, loans made on Prosper are not liquid -- since your money was loaned to someone else, you can't just withdraw it whenever you want. You'll have to wait until it gets paid back from the borrower. However, since I do have a multitude of micro-loans currently funded, I get dozens of small interest payments every month. While I choose to re-invest these payments into more loans, if I wanted I could certainly withdraw them and maintain a very reliable source of income from my investment portfolio. I just personally prefer to use that money to fund even more Prosper loans, so that my portfolio income will grow even faster.
If you're looking for an aggressive investment opportunity, Prosper is one of my favorite investment vehicles for aggressive growth, and I strongly recommend it to all of my readers. You might also want to check out LendingStats.com, which has a lot of statistical information on the investment performance of Prosper.