Ask Money

Peer-to-peer lending

Chris Farrell Sep 28, 2010

Question: We have 3 kids (6,3,1), a 250k house mortgage, a zero-interest car loan, no credit card debt, and 529 plans for the kids (with not enough in them), and 10% of pre-tax income into a 401k. What I’m struggling with is how best to save for the kids’ college and my wife and my retirement. We recently purchased a new home with a very low cost 30-year mortgage, and I had been considering putting extra money into it, with the idea of paying it off (almost) by the time the kids are in college. When I crunched the numbers though, I would need to put $500 a month into the mortgage to get it paid it off in 16 years, saving some $110k. I could take the same $500 a month and put it into the kids’ 529, but over the past 4 years, the their 529s have essentially returned… nothing.

So that led me to think about Lending Club (peer-to-peer micro lender). I put $5000 into Lending Club a little more than a year ago, as an experiment. That money has returned about 11.5% so far. Money you put into Lending Club is not very liquid… although there is some kind of market for re-selling the loans, it seems to me that I need to plan to leave money in there for 3 years before I can get it out (if I want to maximize return). This makes it a bit awkward for short-term saving, but I’m wondering if it wouldn’t be a good way to save money for the kids’ education.

If I took the same $500/month I was going to use to pay down the mortgage, and put it into Lending Club for the same 16 years, it would return about $260,000 at 11%, or even at a very conservative 6%, it would return $170,000. Now, I admit I didn’t even try to account for the tax implications of the mortgage versus the interest income from Lending Club, but it doesn’t seem like any tax issue would erase the difference in return rate. Am I crazy for thinking about doing this? Should I just put it into the 529s and cross my fingers? Or pay down the mortgage? Help. Micah, New Brighton, MN

Answer: My reaction is to either pay down the mortgage or invest in the 529. You’ll be ahead of the game with either strategy. While there is nothing intrinsically wrong with peer-to-peer lending, it’s a risky strategy compared to the two other alternatives you mentioned.

As you know, peer-to-peer lenders connect online people who need to borrow with individuals willing to lend. It cuts out the bank and all the associated overhead costs. The annual loan returns in some cases have been high–in the 9% to 10% range–but there is variation depending on the length of the loan, its interest rate, and credit quality.

Fact is, I’m skeptical that you’ll be consistently a 9% or so return, let 11%-plus return in the current low rate environment. It remeinds me too much of the 1990s saying, “you’ll earn on average 11% in the stock market.” Well, on average Lake Eerie never freezes and there are no stock market crashes, bull and bear markets.

So, while returns on some microloans can top 10%, the average for most loans in the microloan universe is in the 2% and 3% range. So far, default rates are relatively low in the peer-to-peer world, but over time those figures are expected to increase as the loan portfolios age. A higher default rate will negatively impact returns. Right now, the loan experience of Lending Club, Prosper, and other peer-to-peer sites isn’t very long.

The market bears watching. It can be an intriguing way of diversifying a portfolio and having some fun with your money (fun in the money sense of the word). But I wouldn’t put my children’s college education money at risk in a market like this (or my retirement for that matter).

Instead, if you pay off your mortgage early you’ll own your home outright. You’ll be able to say goodbye to the lender. You’ll save thousands and thousands of dollars in interest payments if you’re aggressive in getting rid of the mortgage.

As for the 529, the tax-free withdrawal on earnings that go to pay qualified educational expenses is tough to beat. Yes, the stock portion of the portfolio hasn’t done well. But I would still bet on the performance of a well-diversified portfolio invested in quality securities that gets more conservative as your children near college age in a 529 plan vs. a peer-to-peer lending portfolio.

The Wall Street Journal is gated, but if you have access to the newspaper online it ran a nice story on microlending.

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