Can You Earn 8% Investing In P2P Loans?
While P2P loans are potentially risky investments, they have provided investors with exceptional returns over the last six years. Unless the economy takes a major turn for the worse, I believe that P2P loans should continue to provide investors with high single-digit returns.
What are P2P loans?
Essentially, they are unsecured personal loans to individuals living in the United States. For example, a borrower may want to refinance their credit card debt using a P2P loan. These loans are not secured by any property, like a house or car. The lender (investor) is essentially trusting that the borrower will pay the loan back. Investors in P2P loans typically invest in hundreds of loans, buying a small piece of each loan. (See article: Can't Get A Bank Loan? Turn To Your Neighbor.)
Why are interest rates and investor returns different?
P2P loans usually carry interest rates that are around 2% lower than what the borrower would pay on a credit card. Interest rates on P2P loans typically range from 6% to 30% depending on the credit risk of the borrower. However, it's very important to understand that the interest rate the borrower pays is not the same as the investor's returns. There are servicing fees which reduce returns. However, the biggest reason that the returns on these loans are much lower than their interest rates is borrower default. A large number of people who take these loans do not end up paying them back in full. (For related reading, see: FYI on ROI: A Guide To Calculating Return On Investment.)
What can an investor expect to earn from an investment in P2P loans?
The table below shows the investor returns, including both fees and defaults, for P2P loans based on the years in which the loans were made from the two largest P2P companies, Lending Club and Prosper. The figures for the latter years are not yet final, as most of these loans are still being paid off, and a possibility remains for the borrower to default. On the other hand, the return numbers for 2010, 2011, 2012 should not be changing significantly. For loans issued during those time periods, annual investor returns have ranged from 6.1% to 10.8%. If history is a guide to the future, it would be reasonable to expect a return of 7% or 8%.
Return On Investment for P2P Loans
Data from Nickel Steamroller
Why history may not be a guide for the future
Over the last few years, the economy has been improving. The unemployment rate has been coming down. It doesn't take a genius to know that a person with a job is more likely to pay back a loan than a person without a job. If the unemployment rate were to increase and a significant number of borrowers lost their jobs, a reasonable person would expect that loan defaults would increase. More defaults equal lower returns. (To understand how the unemployment rate is determined, see article: The Unemployment Rate: Get Real.)
What would I tell my friends and mother about investing in P2P loans?
I personally invest in P2P loans because I think that I will earn about 8%. In fact, I have been earning more than 8% during the last 3 years that I have been investing in P2P loans. I have recommended investing in P2P loans to my friends, and at least one of them has followed my lead. However, I have not yet recommended them to my mother. I know that she would be uncomfortable with potential swings in returns and would be more comfortable investing in stable government-insured investments like savings bonds. (For related reading, see article: Savings Bonds For Income And Safety.)
About The Author: Marc Prosser is a successful entrepreneur and publisher of Fit Small Business, a product and service review site for small businesses.
Disclaimer: The opinions expressed are those of Marc Prosser of Fit Small Business and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of any individual holdings or market sectors. This material does not constitute any specific legal, tax or accounting advice. Please consult with qualified professionals for this type of advice.
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