Investing in Lending Club and Prosper

Americans are cleaning up their debt, according to Federal Reserve data. But they still have a long way to go. Aside from the more than $1 trillion of student-loan debt outstanding, there’s still more than $800 billion in credit-card debt borrowed at terms that often exceed 20 percent annually. Meanwhile, the same banks that see fit to charge 20 percent or more for revolving debt continue to pay savers 1 percent or perhaps 2 percent on their deposits.

Though that may sound like highway robbery, the 18-percentage-point spread has created a business opportunity: marketplaces that bring together debtors and lenders. Not all of those debtors have poor credit; far from it. In fact, at least some of them are considered relatively good credit risks with reliable income, contributing to the growth in peer-to-peer lending and making it a new force in the financial system.

The two largest peer-to-peer lenders, Lending Club and Prosper, both with headquarters in San Francisco and Internet-based, have grown from curiosities in 2007 to an online lending duopoly that facilitated more than $2 billion in loans in 2013. (There are other peer-to-peer lenders, but those two established firms are dominant, controlling almost all of the existing market.)

The peer-to-peer business is still small potatoes compared with the credit-card units of American Express, Bank of America, and Chase. But it’s potentially lucrative for thousands of investors in the 30 or so states where it is permitted. Some are even using peer-to-peer loans in their individual retirement accounts. As a result, it’s not surprising that institutional investors are now getting in on the action.

Here’s how peer-to-peer lending works: After opening an account online, the investor browses hundreds of borrowers’ requests for a loan. The requests are accompanied by a brief statement (no more than a line) about how the borrower intends to use the loan. In the majority of cases, the reason is the same: The loans are intended for debt consolidation.

The more important piece of information for the investor is the credit rating Lending Club and Prosper assign to the loan. That helps determine the potential return for the investor, which can vary widely. At Lending Club, recent annual returns ranged from 6 to 13 percent.

When it comes to making a loan, it is not an all-or-nothing deal. If a single borrower is seeking $16,000 in loans, you can lend any portion of that amount in increments as low as $25. For the investor, making smaller loans to multiple borrowers instead of one big loan to a single individual is a way to reduce risk by diversifying investments among borrowers.

By lending, say, $100 to 20 debtors with the same rating, instead of $2,000 to one debtor, you reduce the risk of choosing the borrower who defaults on a loan. According to a 2012 analysis by the website Lend Academy, default rates on Prosper and Lending Club loans, across all credit risks, ranged from 1 to 9 percent. That means that for higher-yielding, higher-risk loans, you can expect about one out of 12 loans not to be fully repaid, which will put a dent in your returns.

Wall Street has taken notice of the growth in peer-to-peer lending companies. Lending Club, the larger of the two peer-to-peer lenders, announced in April that it had acquired Springstone Financial, a company that aims to provide affordable financing options for consumers, for $140 million. Lending Club appears to be preparing to take its business public through a stock offering sometime later this year.

Some hedge funds have taken notice as well, using in-house computer trading programs designed to snap up loans with the most attractive risk-reward ratios. One effect of that is they compete with individuals for the existing pool of peer-to-peer borrowers.

The second effect, though, may be changing the marketplace. The hedge fund “investors” tend to gravitate toward the riskier loans—those that will return in excess of 10 percent to the lender. So there may even be a market for borrowers with a riskier profile than, say, the newly minted M.D. with loads of debt.

Now it looks as if the two big peer-to-peer lenders are trying to bring in more borrowers to feed the new investors. Both solicit borrowers using methods similar to those used by credit-card issuers. Lending Club sends direct mail to its target market, and Prosper uses social media ads on sites such as Facebook that read: “Escape your credit card debt. Unsecured personal loans through Prosper. Checking your rate does not affect your credit score.”

More of those riskier loans may go sour, of course, but fortunately for the rest of the country, peer-to-peer lending isn’t “too big to fail.” Yet.

This article originally appeared in the August 2014 issue of Consumer Reports Money Adviser.