Peer-to-Peer Lending Risks During a Recession

by Kevin on February 25, 2009

Peer-to-peer lending is risky in my eyes. You are lending money to (usually) strangers and hope that there is enough incentive for them to pay the loan back (dinging their credit). We talked on Monday how you can earn some high returns with social lending. I’m not saying I think you shouldn’t do peer-to-peer lending at all. You just need to be really, really selective in who you lend to, who they are sponsored by on the social lending sites; essentially becoming a tried and true loan officer.

Is Social Lending More Risky in a Recession?

Talk about throwing up an underhand pitch to knock out of the park.

The economy is bad. Really bad. People are losing their jobs left and right. Some of them may be asking for loans from you and me. You’ve got to be diligent.

The peer-to-peer lending sites (like Lending Club) try to protect their lenders as best they can. Lenders can grill the person requesting a loan on their job history, chances of getting laid off, household income, and debt-to-income ratios. This seems to promote a healthy dialogue between the lender and the lendee, and I’ve seen it happen on multiple loans. (Not that I have funded, but just browsing around on the site).

Recession Impacts on Peer-to-Peer Lending

A few quick tips:

  • With the economy going down the tubes, one might expect a higher number of loans at social lending websites. Why? Well it isn’t just individuals who use the sites. Small businesses do, too. Their bank funding may have dried up right when they were trying to expand. I would expect individuals to also come out of the woodwork. Some good, some bad. Again, due diligence is key.
  • Indeed you can earn returns higher than the stock market with personal loans. Some have looked at social lending as an alternative to stocks and bonds. Then again with the market dropping 50% since it’s peak in October 2007, beating the stock market isn’t exactly a difficult task.
  • Take into account where the person works and how long they’ve been there. Ask about their other assets. Some people borrow to consolidate debt and have other relatively liquid assets they could tap if they lost their job. I am more inclined to lend to these people than the person who just started a new job in the mortgage industry. Be smart.
  • Never put 100% of your portfolio in anything. Diversify your assets among multiple asset classes. If lending is one of those, that’s up to you. But don’t pull all of your retirement money out and start lending like crazy on Lending Club.
  • Within your loan account, diversify. Never put 100% or even 50% of your assets into one loan. You can break this rule if you have a very small portfolio like me. I’ve got $50 in Lending Club spread out among two loans. But if I had $1,000 I would have 40 loans. Keep that ratio.
  • Beware of sketchy loan requests. If the numbers don’t add up it will be blatantly clear. If the rest of the community is avoiding the loan, you should, too. The key here again is discretion. You can find a diamond in the rough that not many people have funded. You can also jump on the bandwagon of a bad loan. Keep your head on your shoulders and be careful.
  • Along with the above point, I can see people hopping that are about to foreclosed on, just trying to grab a wad of cash to take with them. Their credit is already shot, so why not steal some money from random strangers? Again. Be. Careful.

Good luck out there trying to earn high returns. If you had diversified 50% of your overall portfolio to social lending and had no defaults, you would only be down 20% or so overall with the way the markets have been recently. But I don’t recommend doing that just yet.

What do you think, readers? Are you social lenders? Is it more risky during a recession?

{ 7 comments… read them below or add one }

Stephanie PTY February 25, 2009 at 11:29 am

I signed up for LC this week, and I’ve started playing with just the $50 bonus. I don’t have income to invest right now (cause this is such a great time to be graduating college!), so it will probably be a while before I put any of my own money in, if ever. I like the idea of just watching to see what happens to my “fun money” that’s in the account. Maybe after a year, I’ll put some of my own cash in.

Reply

Personal Finance Firewall February 25, 2009 at 7:38 pm

I think this is always risky regardless of the economic state but it gives a higher return for the risk and that is why it is a favorable method to make a return now, and any time. I mean peer lending is based on a person to person basis. A persons financial situation could be bad or worse when the recession clears up.

Reply

Kevin February 25, 2009 at 9:05 pm

@Stephanie: That’s essentially what I did. We will see what comes from it. I may continue to invest my profits and one day we’ll both have millions 😉

@Personal Finance Firewall: Very true, but I would prefer to really know the person before I just handed out money.

Reply

Stephanie PTY February 25, 2009 at 9:28 pm

@Kevin: hmm… let’s see… $50 present value, at 13.5% for 40 years with no additional payments is… $7,921.45! Not exactly millions, but not bad either.

Reply

Tiffany February 27, 2009 at 1:52 pm

Instead of P2P lending, people should try getting a loan at a financial cooperative (a credit union). You get the benefit of members pooling their money (which results in more affordable rates) without all the risk. Of course, the best situation is to not borrow at all, but if you have to, make banks your last resort!

Reply

Kevin March 5, 2009 at 9:25 pm

@Stephanie: Ah, good math. Better than negative 50%!

@Tiffany: Very good point. As I said I am not sold on this. Is it possible that someone might get turned away at a credit union and there only resort would be personal lending? (I wouldn’t be interested in the loan in that case, but just curious).

Reply

Tiffany March 6, 2009 at 6:54 am

If you are referring to getting turned away from a credit union in regard to membership, you do have to be eligible to join a credit union. However, most people have access to one. Some credit unions are offered as an employee benefit (as your HR department if you aren’t sure), and some credit unions offer membership to anyone who lives/works/worships/volunteers in a geographical area.

If you are referring to getting turned away from the credit union in regard to being denied for a loan, sure, this can happen. You do have to qualify, and credit unions do have conservative loan practices. However, credit unions make loan decisions differently from banks…they consider other factors that banks often do not. They look at the whole situation, rather than ruling out the borrower because of numbers alone. Their niche is the average Joe that banks oftentimes don’t care about.

Reply

Leave a Comment