Is Being a Peer-to-Peer Lender a Good Way to Invest Your Money?

Regular listeners of the Motley Fool Answers podcast will know that Alison Southwick and Robert Brokamp are full of excellent investing and personal finance advice. But for this episode -- which they are dedicating totally to listener questions -- they've called in reinforcements: Ross Anderson, a certified financial planner from Motley Fool Wealth Management, a sister company of The Motley Fool.

In this segment, they consider the risks versus rewards of being on the lender side of peer-to-peer lending. The returns are better than you'll get from bonds, though worse than the average return from the stock market. But where does it fall on the risk spectrum, and is it reasonable to consider those assets as a part of your emergency fund?

A full transcript follows the video.

This video was recorded on Feb. 27, 2018.

Alison Southwick: Ross, here you go. This comes from Joe. "Have you ever done an episode on the investment potential of peer-to-peer lending platforms, such as Lending Club, Prosper, etc.? I'm curious about your take on them as a potential alternative to CDs, money markets, etc., for stashing emergency or savings for other items like cash we don't intend to put in the market.

For background, my wife and I are 30 with two young kids. We maxed out my 401(k), our IRAs, and 529s for the kids, matched to the state deduction, and these peer-to-peer lending platforms advertise a 4-7% historical return, but they also seem a little too flashy and slick, and I'd be curious to hear your take, so I don't accidentally dive into an over marketed, underperforming option."

Before we get to the question, can you explain a little bit about what it means to invest in a peer-to-peer lending platform?

Ross Anderson: Peer-to-peer lending tries to match up borrowers that need funds for something, whether it's a home improvement, credit card consolidation, anything...

Southwick: Anything.

Anderson: They're unsecured loans in most cases, so anything that the borrower needs it for. And then they are trying to do the credit analysis, figure out how risky is that person, and then match them with people that are looking to lend money to other people. They're just a facilitator -- they're a middleman -- trying to match you with borrowers if you're on the investor side.

The benefit, there, is that you're going to get a piece, or the majority of that interest rate that the borrower is paying. They're saying banks have been lending money for years, whether they've been easy to deal with or not. How can other people get into this space? That's what peer-to-peer lenders are trying to facilitate.

Southwick: Let's say Bro wants to put on an addition to his already massive mansion house that he has. I'm just teasing.

Robert Brokamp: I do not have a mansion house.

Southwick: A mansion house. That's not even a phrase people use. Welcome to my...

Brokamp: A mansion.

Southwick: ... mansion house.

Brokamp: Mansion house.

Southwick: So, Bro wants to do an addition and I want to loan someone some money. Does this peer-to-peer lending platform say, "OK, Alison, we've matched you. We're going to Match.com you to Bro." Are you literally waiting for him to pay you back, or does it all go into a great big fund and it all gets dispersed?

Anderson: It's not all pooled. What's actually happening is most of the time you're not funding a single person's whole loan. There's a bunch of people satisfying any single loan. You might say, "I need $25,000 for my llama farm or something." They're going to then put that out there as an offer. This is a borrower. This is their credit rating. This is roughly what they want to do with it and then people can bid on that loan. So, you might end up with 300-400 people that have leant into what makes up the full $25,000.

And so, they're trying to spread that risk, that if there's a single default, it doesn't take one person down. But you can choose how much of the loan you want to fund on any given product.

Southwick: So, with that in mind, that's how it works. Is this something that Joe should use for an emergency fund or saving for other items fund? That's how he described it -- saving for other items.

Anderson: I would not ever use that for an emergency fund.

Southwick: OK, Joe. It's no.

Anderson: I think of it very much like buying a bond. If you're otherwise investing in debt or buying bonds, I think this is an alternative to that. Or if you were having longer-term money in CDs. But this is much higher risk than a CD. There are defaults on these platforms. Nobody gives away 4-7% risk-free, so there is absolutely an additional risk for the additional return that you're getting.

But if you've got some mid-term money [not emergency fund, but maybe not long-enough term to be in stocks], I think that these are an interesting intermediary vs. corporate bonds or municipal bonds that you can get a little bit of a higher return. You're also going to have to do a little bit more work for it, because you do have to look at the loans that are available to issue, and bid on those, and decide how much you want to put into each loan. There is some work on your end as the lender, so be prepared for that, but definitely don't do this with your emergency savings.