Risks and Rewards of Online Lending

Alex Clemens invests in the hopes and dreams of other people -- and earns about 13% in interest for doing so. With Prosper.com, he lends money to people in need, whether that need is money for graduate school, to get out of debt or to start a business.

Clemens, who's been lending for almost a year, was attracted to the Web site for two reasons: It offered a way to extend help to people directly, and the investments would diversify his assets. "It's a much more interesting part of my portfolio than my stocks or my condo," he says.

The challenge is figuring out who's a good risk. Clemens acts as a "mini bank," examining credit ratings, endorsements and what the money will be used for. He doesn't lend to people with poor financial records unless he is confident they'll repay the loan.

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Risk versus reward. With online lending, one thing you can usually rely on is a trade-off. Lend to a borrower with bad credit and you can expect a higher interest rate. A borrower with a better credit history will get you a lower rate. It's easy to find loans that promise interest rates of 25% or better, but making them is a gamble. With most loans, there is no safety net, whether you know the borrower or not.

The key to success is twofold. First, find your balance -- a risk you feel comfortable taking and a return you're content with. Marilyn Paguirigan, a two-year veteran lender on Prosper, says she chased "sexy, double-digit rates" in the beginning and has already seen some of those loans default. She's since become more conservative and counts herself happy when she earns 7%. "I'm getting more than I would in a money-market account and I sleep well," she says.

The second half of the formula is to think like an investor. Although your motivation may lean toward the social aspect of social lending, you should evaluate a borrower with just as keen an eye as you would evaluate a mutual fund.

Scott Powley took that approach when lending to a friend on Virgin Money. His friend was having trouble getting a loan because he was between jobs. But his friend owns property, so Powley agreed to structure the loan as a second mortgage. Powley is a broker, and he went through the underwriting process himself, looking at the appraised value of the home, its location and what was owed on the existing loan. "Everything fell into place," he says. Powley decided that a 12% interest rate was a fair payback for his risk -- the bank was offering his friend a 17% rate (plus several thousand dollars in fees and closing costs). "If you know the scenario, there's no downside," says Powley.

Peer-to-peer lending takes many forms, and the one that's right for you (if any) depends on how much risk you're looking for and whether you know someone who needs money.

These online-lending sites cover the spectrum:

1. Riskier Return: Prosper.com

2. Safety First: Zopa.com

3. Lend to a Friend: VirginMoneyUS.com

4. What's New? P2P Loans for College