Is P2P Lending a Good Way to Make Money During Retirement?

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Peer-to-peer lending (also known as P2P lending) has gone from a hot fintech trend a few years ago to a popular and legitimate way for investors to earn a stream of income today.

As this type of lending gains popularity because of its relatively high expected returns and low-cost entrance into the market (an investor can start with as little as $25), we look at what P2P lending is, and examine some of the possible risks and rewards.

What is P2P Lending?

P2P lending leverages different types of technology – from online payment and investing capabilities, to Big Data that predicts the likelihood of loan repayment to create interest rates. It then anonymously matches investors with borrowers via online services based on factors, such as risk/reward, interest rate/return, credit report, debt-to-income ratio, and type of loan (personal, small business or refinance).

For example, a borrower can request a loan for $2,000. An investor would lend a portion of that amount – this could be any amount, from as little as $25 to the full amount. Certain states have limitations on the amount that you may invest, but under no circumstances can you purchase notes in excess of 10% of your net worth (exclusive of the value of your home, home furnishings, and automobile). 

If you decide to only put up a portion of the loan, then you would share that loan with other investors. This is where diversification comes in; the more you spread out your investments among many loans, the lower your risk from a single default.

By eliminating overhead costs like physical branches, P2P platforms can lower costs for investors.

P2P History and Projected Growth

Born from the financial crisis of 2008 and the resulting banks’ tightening of lending standards, P2P lending is a way to create personal loans that Big Banks either won’t finance or will charge more for. It also gives some investors the chance to capitalize on high interest rates. By eliminating overhead costs like physical branches, P2P platforms can lower costs for investors.

How Money Is Earned

Most P2P companies earn their money two ways: 1) They tack on origination fees to the borrowers’ loans, and 2) They take a portion of the loan repayments made to investors.

P2P loans are unsecured and typically range from $1,000 to $40,000 (bigger loans are available for businesses and lines of credit) and the APR can be anywhere from 5.32% and 36%, according to Prosper and Lending Club, two of the largest and most popular P2P platforms.

The average loan tends to be for 30-to-60 months. According to statistic site NSR Invest, for the first three quarters of 2016, the average investor ROI for Lending Club loans was 5.96%, while the APR for borrowers was about 13.46%, and the average loss was about 6.70%. This data comes from 434,407 loans with a total amount of $6,400,541,700.

Some Pros & Cons of P2P Lending

Pros

  • Opening a taxable account online is easy and inexpensive; initial investments start at $25
  • Diversifying risk is possible and wide-ranging as investors can fund hundreds of loans with varying loan grades
  • Higher average returns than bank CDs, but potentially with more risk
  • Potential to collect monthly income via repayments and interest from borrowers

Cons

  • Interest is taxed as ordinary income, making P2P tax inefficient if used in a taxable account
  • Opening IRA accounts requires a third-party custodian and is a bit more work and cost to set up
  • High-risk loans with high interest rates can be risky in a recessionary environment
  • P2P platforms can default and even be entangled in fraudulent practices by borrowers, such as identity theft, fake bank accounts, fake businesses and loan stacking, all of which puts your money at risk
  • You are committed to the terms of the loan – some loans have a secondary market but you can expect to take a big discount if you want to sell early

Exercise Caution with P2P Lending

Historically, the returns have been in the high single digits, 7%-to-9% range. But investors should be cautiously optimistic about P2P lending. It’s important to keep in mind that P2P lending hasn’t been around long. There are two things to consider here:

  1. P2P lending is thriving during a period when the economy has been good, so there’s not that much consumer default. Default rates will likely rise if the economy softens.
  2. It’s a new piece of the market, so there’s less competition amongst each other.

So, people should expect positive returns over time, but not necessarily every year and not as high as we’ve seen the last several years.

Companies like Lending Club and Prosper help investors manage risk by allowing them to choose the loan grade they want to invest in, such as Grade A, which is considered low risk, through G, which is considered high risk. The lower the grade, the higher the risk, but also the potential for a higher return, and vice versa. A recent Forbes piece on P2P lending states that although default rates are higher on grades D-G at Lending Club and grades D-HR at Prosper, the potential ROI is higher too.

At Personal Capital, we don’t believe you need to utilize P2P lending and that you can build a solid, diversified fixed income allocation without this type of investing. If you do invest, we recommend that you limit loan investments to no more than 10% of your portfolio and only as a fraction of your overall fixed income allocation. This type of investing is new, so you don’t want to sink all of your savings into it. You also should be aware that if the P2P company itself goes bankrupt, then you could lose your money on your investment.

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The Takeaway

Ultimately, P2P loans are a nice innovation that create more choice for investors and borrowers. As with any investment, it is important to consider how this type of investment fits into your overall portfolio and whether it can help you better achieve your financial goals.

[Schedule your consultation with a Personal Capital advisor today]

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Craig Birk, CFP®

Craig Birk, CFP®

Craig Birk is a member of the Personal Capital Advisors Investment Committee. He also serves as Vice President of Portfolio Management. Prior to Personal Capital Advisors, he was an integral leader within the portfolio management team at Fisher Investments. During Craig’s time there, the company increased assets under management from $1.5 billion under management to over $40 billion. His responsibilities included risk management, portfolio implementation oversight, and management of all securities and capital markets research analysts. Mr. Birk graduated from the University of California at San Diego and has earned the Certified Financial Planner® designation.

6 comments

  1. MyFiIntheSky

    Thanks for the good write-up. I experimented with some loans on Prosper, and have been earning 20% on my little account of about $4,000 so far. I stopped investing more money though, as I feel the risk/reward analysis just isn’t that great. These loans will default like crazy during an economic event. I like collateralized lending better, even if the return is a tick lower right now. But to each his own–obviously the returns from P2P lending can be pretty killer if you know what you’re doing.

    Reply
  2. RAnn

    IS there any plan to be able to link Lending Club and Prosper accounts to Personal Capital?

    Reply
    • Anonymous

      I have had my LC account linked for a while.

      Reply
    • Planecrash

      You already can! I’ve been monitoring both of these accounts, with Personal Capital, for quite some time now.

      Reply
  3. Dave S

    I have usd P2P lending for a while and agree with all of the caveats in the article. The net returns are lower and the total fees higher than indicated. Its also a bit messy at tax time, with limitations on the deductibility of losses. Losses of 6 to 10% don’t sound like much, but they are easily half or more of the income, with losses rising over time. The vetting process is inadequate in my judgment, with far too many loans defaulting, especially within the first year. Nonetheless, loan returns exceed those of the usual fixed income sources. The biggest advantage is that they constitute a separate asset class, so returns do not correlate with other investments, and asset values are stable over time.

    Reply
  4. Scott L

    Not to mention that P2P lending isn’t even available in all states. I happen to live in a state (which happens to have a strong big banking presence) where the P2P lenders don’t even seem to want to try to do business at all.

    I would personally love to know your thoughts on the new real estate and bond ‘community’ investing options. It seems like regulations haven’t kept up and there’s a good chance to get burned good. But it also seems like it could be a way to navigate the middle ground between REIT and personal property that you have to manage and take on full risk yourself.

    Reply

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Disclaimer. This communication and all data are for informational purposes only and do not constitute a recommendation to buy or sell securities. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Certain sections of this commentary may contain forward-looking statements that are based on our reasonable expectations, estimate, projections and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.