Avoid these Risks in Peer to Peer Loan Investing

peer loan investingThe emergence of online investing platforms opened the door to low cost stock investing in the late 90s but the benefit has never extended to fixed income investing. Investors looking for their allocation to safer, income-producing bonds still pay relatively higher fees and have difficulty buying enough bonds to diversify their portfolio.

That is, until peer lending became available just before the financial crisis. The idea couldn’t be simpler, borrowers would apply directly to investors with platforms taking a percentage to originate the loans and process payments. Borrowers pay the fees and investors put as little as $25 on each loan in their portfolio.

Peer lending platforms like Prosper and Lending Club have bounced back from the Great Recession and demand for peer loans nearly doubles each year. The loans have become a great new asset class for investors, saving money on fees and offering the ability to diversify risk across hundreds of different loans.

But returns averaging 9.3% a year are not without risk, a fact within any asset class investment. I get emails almost daily from investors, still reeling from 2008, about how to take advantage of the upside in peer loan investing and avoiding the risks.

There are three major risks in peer loan investing, risks that investors in other assets will recognize but with a peer lending twist.

Diversify your Peer Loan Portfolio

Your portfolio of peer loans should hold at least 100 loans to make sure defaults in a few do not completely wipe out your returns.

The graphic below shows diversification in loan portfolios on Lending Club. Holding less than 100 loans leaves your portfolio return up to the mercy of luck that the default rate on loans will be better than average. Once your portfolio reaches about 200 loans, the difference in returns evens out and your overall return will likely follow the average.

investment-diversification - Copy

I like to keep more than 100 but less than 200 loans in my portfolio, buying more loans as others mature. This gives me the opportunity to beat the average return through good loan selection but doesn’t leave me too exposed to one or two loans. Investors can put as little as $25 towards each loan so this kind of diversification is within reach for most.

Don’t go Chasing Waterfalls in your Peer Loan Investing

The biggest risk I’ve seen for new peer loan investors is the temptation to load up their portfolio with loans from the riskiest categories of borrowers. Borrowers in these categories pay rates upwards of 30% and too many new investors think that translates to early retirement.

As with all investments, higher potential returns is a sign of higher risk. Rates are so high for the high-risk categories because they have to compensate for a higher rate of defaulted loans. While investment in the riskier categories still pays a good return after losses on defaults, the stress for many investors as loans start going bad is just too much.

Investors not comfortable with volatility run the risk of freaking out when loans start to default in their portfolio. This leads to panic selling and the investor sours on the whole concept of peer loan investing. As with any investment, understand your tolerance for risk and only invest in the categories in which you’re comfortable.

Be Wary of Secondary Trading in Peer Loans

Secondary trading has always been difficult for bond investors. Trying to sell out of your bond investments has usually meant higher costs to find a willing buyer. The secondary market in peer lending is just opening up but costs are relatively high and panic-selling will be a risk to returns. While borrowers pay fees associated with originating a loan, investors face fees for buying and selling loans in the secondary market.

As more people get into peer loan investing, a market will develop for analysis attempting to tell investors exactly when to buy and sell their loans. This is the worst kind of investing for most people and could seriously limit your returns. Resolve to hold your loans through maturity and save money in trading fees.

Peer loan investing offers the potential to lower the risk in your investments by adding a new asset class and returns have been on par with stocks. As with other asset classes, make sure you diversify across many investments and don’t chase high returns if you’re not ready for higher volatility. Hold loans to maturity and avoid constant trading to minimize fees.

Joseph Hogue, CFA runs PeerFinance101, a blog where you share your stories of personal finance challenges and success. There’s no one-size-fits-all solution to meeting your financial goals but you’ll find a lot of similarities in others’ stories and a lot of ideas that will help you get through your own challenges.

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