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Question:


I’ve heard good things about peer-to-peer lending as an investment vehicle. For instance, Lending Club seems to be gaining in popularity, with annualized returns of 9%. Are you a fan?
-DainaS


Answer:


Lending Club and similar organizations act as go-betweens for lenders and borrowers. Lending Club’s credit staff appears to be very rigorous, rejecting about 90 percent of loan applicants. The ones it accepts are placed in categories of varying creditworthiness labeled A through G. Being farther from the beginning of the alphabet corresponds to a lower credit rating and higher interest rate. Lenders make their loans indirectly by purchasing a note that corresponds to one of the credit groups and is much like a bond. They receive payments based on the interest rate for that group, minus a 1 percent annual fee and losses from any defaults, which generally are low.
 
Borrowers go through Lending Club because they can’t find better rates elsewhere, and lenders find the returns more attractive than those available in the financial markets or the bank. But just how attractive are they really? The average annualized net return for loans across all Lending Club credit classes is, as you point out in your question, around 9 percent. That sounds very good, but whether it stays that high remains to be seen. If the economy worsens, defaults are likely to rise.
 
Perhaps a bigger issue is the way repayments are structured. As with a typical mortgage, Lending Club borrowers pay a monthly mix of interest and principal, and that’s what lenders receive. If you lend $100,000 at 9.5 percent a year for three years, you won’t get $128,500. As the Lending Club website explains, you’ll receive about $3,200 a month. Over 36 months that adds up to $115,200. That is indeed an annualized rate of 9.5 percent, but it probably doesn’t feel like it. What do you do with your monthly payments, put them in the bank and earn 0.1 percent? Unless you want to do this for social reasons – some see these organizations as a cross between banks and social networking websites – then you would probably be better off investing in a high-yield bond mutual fund or even a fund that focuses on high-yield stocks.
-Conrad de Aenlle



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