Look for a Higher Return? Consider Lending to a Peer

Alternative investments don’t have to involve hedge funds or private equity firms.

By Matthew Mogul, Associate Editor, The Kiplinger Letter

July 9, 2007

Investors looking to avoid volatile market swings are increasingly lending out money, often to cash-strapped entrepreneurs and small business owners. The trend, known as peer-to-peer lending, typically involves people with a little cash on hand donning the hat of amateur banker and making loans to anyone from a friend or family member to a stranger that they were introduced by an Internet matchmaking firm. Peer-to-peer lending will skyrocket to $5 billion by 2010, up from just $300 million last year.

The approach works well for both parties -- and for the middleman Web site, which collects fees from both sides. People lending out cash today can rake in better returns -- 6%-7% -- than they would by parking their money in a Certificate of Deposit or money market fund. Small borrowers, meanwhile, pay much smaller fees than would if they went through a conventional bank. Plus, many banks won’t consider loans as small as a peer would -- sometimes as little as $1000. That amount frequently forces a small business owner to take a cash advance on a credit card or head to a payday lender, either of which can mean exorbitant interest rates. With peer-to-peer lending, borrowers can go online, state how big a loan they need and how much interest they’re willing to pay. On some Web sites, lenders bid for the chance to make the loan.

This Internet-based direct lending model is a cross between microlending and popular social networking sites. Sites like Prosper.com and LendingClub.com allow borrowers that share common interests to group together, much like the MySpace and Facebook sites. Lenders can then seek out borrowers they identify with, such as alumni from their university or sports fans who support the same teams. This personal touch appeals to many lenders.

But lenders need to pay attention to the risk of default. Even though borrowers must submit to a credit score check along with other verification, those with average credit scores fail to pay back what they owe about 3% of the time, a little more often that the 2.1% default rate that banks average. And if a borrower skips out, the only recourse is for the Web site to notify the national credit bureaus and then turn the loan over to a collection agency.

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