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Intrigued by social lending

Chris Farrell Nov 30, 2010

Question: I love listening to Market Place Money and have so many questions, but I’ve been able to decide on this one. My wife and I have done a really good job of getting an emergency fund set (roughly 4 months worth of expenses), but the 1.09% APR I’m getting on my savings account is killing me!

I recently heard about a Website called ‘Lending Club’. In just my cursory review of what they offer I realize that it’s not a savings account, but this 1.0% return on my money in my savings account is really starting to get to me. And with the Fed’s seemingly endless policy of low interest rates I’m at my whit’s end. What to do? Keep the money in the safe low return savings account? Put some of the money into this ‘Lending Club’? Buy gold? Go on a vacation and try to singlehandedly pull the country out of the great recession hangover? Ahhh!!! Anyway, love the show. Thanks. Ryan, Bermuda Dunes, CA

Answer: Ah, a vacation sounds nice. Okay, I have to stop staring at the snow outside my window and dreaming of walking along a sandy beach. On to your question!

The frustration over low rates on savings is growing. It isn’t easy to set the money aside and then you get paid an interest rate of 0.1% to 1.2%. (Imagine, banks are marketing accounts paying 1.2% as “high-yield”!). Still, the good news is that your money is safe and it will be there when you need it.

I find the rise in peer-to-peer lending fascinating. The peer-to-peer websites bring together in cyberspace individual lenders and individual borrowers. It cuts out the bank and its overhead costs. The business is an intriguing combination of Match.com, Facebook.com, and Ebay.com.

Peer-to-peer lending and borrowing is about money and community. I wrote about peer-to-peer lending in a post earlier in the year. A decent overview of social lending is offered at Mint.com.

The Lending Club is a major peer-to-peer player, along with Prosper.com. The Lending Club opened for business in 2007 and its net annualized return for lenders has been 9.67%. (Net annualized return is a formula where the numerator comes from the interest received from loans, plus any late fees received, minus the 1% service charge the company imposes.) Not bad, huh. It’s a lot better than 1%.

Neertheless, I remain a peer-to-peer lender skeptic. Remember, on average Lake Erie never freezes and the stock market has returned about 11% since 1926. Have you looked at your stock portfolio lately? I’m betting the return over the past few years has been a lot less than 11%.

What’s more, you can’t make almost 10% on your money in a 1% interest rate world without taking on greater risk. There are very few laws in finance, but the trade-off between risk and return is a durable relationship.

My guess is that with time it will become apparent why financial institutions have credit departments (at least when management pays attention to them).

The returns on peer-to-peer loans vary considerably, depending on the length of the loan, its interest rate and, perhaps most importantly, the borrowers credit quality. The loan experience of Lending Club isn’t that long, either. Before putting your hard-earned savings at work in a peer-to-peer lender I’d do some research. Check out the lending forums at Wiseclerk. And this site uses a different methodology to calculate Lending Club returns. When I look at the data it reinforces the message that credit quality really matters.

In other words, peer-to-peer lending hasn’t eliminated risk. The key investment question is always: “What is the downside? What could go wrong?”

That said, I do think that peer-to-peer lending can be fun for people who want to act as banker. You can limit your downside risk by lending very small amounts–say, $50–to several different borrowers. I’d also stick to borrowers with higher credit ratings. It’s an intriguing way of diversifying a portfolio assuming it’s your idea of fun. To me, it isn’t all that different from picking individual stocks. It’s entertainment. The money comes from your entertainment budget. And hopefully you’ll make some money along the way.

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