Now, if you’re chasing yield, and you’re trying to make your fixed income do better, then all bets are off. That’s a dangerous game. Carl Richards

I’ve been getting a lot of questions lately about peer to peer lending as a way for investors to increase their yield in a low interest rate environment, so I thought I’d give my take. Peer to peer (P2P) lending involves borrowers going to a P2P website and asking for a loan from individuals. Their credit worthiness gets rated by the P2P originator and individuals can choose which loans to invest in (or lend their money to).

You get to choose the loans you put your money into depending on the borrower and the yield you’re seeking.

Prosper, one of the more well-known P2P organizations, currently advertises rates between 6.73% and % for borrowers on their website, which can lead to interest rates of 6-12% for investors.

I think the P2P model is a very interesting idea. Anything that increases competition for the banks is good in my view. But this is still a new and emerging industry with a short lifespan. Many issues need to be understood by the investors before they dive in.

This allows investors to find a wide range of interest rates, based on the credit quality of the payday now loans Guthrie OK different loans

• There is no skin in the game for the P2P companies. They are basically just the middlemen that handle the processing and are intermediaries for the loans. They take no risk, but they do take a fee from each loan.

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• Since they take no risk (the lenders take all the risk) why wouldn’t the banks simply take over this industry? If they could facilitate loans while skimming a bit off the top without having to carry any risk on their balance sheets, why wouldn’t they do this? I’m sure there are political and regulatory reasons but if the banks could facilitate these loans, they could offload tons of risk and make huge returns.

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• As bad as banks were in the housing bubble, they are still much better than the average investor at credit analysis and determining the quality and riskiness of loans.

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• In a way this is how the 2008 debt crisis was amplified. The banks and other investors in mortgage-backed debt securities simply collateralized all of their debt and sold it off to investors, thus decreasing the need for the banks to closely monitor the performance of the loans. It didn’t matter to them since it was off their books (well, most of it) and investors didn’t care because they were reaching for yield (something P2P lenders may be doing now).

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• Interest rates for P2P lending look great because the history of the default rates only go back a few years. I know that there are probably many highly respectable individuals that are taking out loans from these places and they will pay them back on time with no problem. But the creditworthiness of some of these borrowers is bound to be suspect if they can’t get a loan from a traditional source. Some P2P lenders allow them to sign up and be approved for a loan in minutes. Sound familiar? Think NINJA (no income, no job) mortgages in 2005-06.

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• The P2P companies have much less incentive to correctly screen for the risks in the loans and creditworthiness of their clients than the banks do.

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• The % rates at the high end are similar to the rates you would see from a loan shark or payday lender. Borrowers at these types of rates are usually in a fix, so don’t count on those types of loans paying off in the long run. If it sounds too good to be true it usually is.

Citigroup suffered losses in 2008 that were more than one-quarter of the cumulative profits from the previous seven years because of subprime loans. I think that could be the template for P2P lending a few years of decent gains followed by periods of large losses. It works and works until it doesn’t. Here’s what this could look like:

I’m not saying this will happen, only that it could happen. You should always see both sides when making an investment.

The rates vary by the borrower’s credit rating (as determined by the P2P company)

US households average $149,782 in mortgage debt, $34,703 in student loan debt and $15,328 in credit card debt. Remember the subprime mortgage crisis? P2P borrowers are basically subprime.

As we saw in the mortgage crisis, defaults tend to come in waves. By , almost 15% of all mortgages outstanding were delinquent or in default. Many of these borrowers had decent credit. Not all were subprime borrowers.

This allows investors to find a wide range of interest rates, based on the credit quality of the different loans

• Diversify and spread your risks over a large number of different loans.
• Understand the terms before investing. This includes the term of the loan and the fine print (fees, payment schedule, etc.)

Those are my concerns and advice. Again, I think this is a great idea as it plays off of Kickstarter and other crowdsourcing ideas. I just want investors to be aware of the risks that can be involved when lending money to other individuals or small businesses.

*Update P2P lending was featured in the WSJ today if you’d like to read more: Consumers find investors eager to make peer to peer loans (WSJ)