With yields on Treasury bonds at 3 percent or less and savings account rates near zero, investors are starved for income. Is peer-to-peer lending a possible answer?
Peer-to-peer lending, in which investors and borrowers arrange loans without a traditional bank in the middle, has blossomed into a multibillion dollar business. In exchange for putting up the loan principal, peer-to-peer lending can offer investors a healthy rate of income.
However, the approach is still too new for the risks to be fully recognized by the marketplace. Before you invest in a peer-to-peer lending opportunity, here are six things you should think about.
1. The track record is incomplete
Promoters of peer-to-peer lending will show you statistics to reassure you that yields have been more than enough to make up for defaults. However, this has previously been the case with new markets, from international bonds to mortgage-backed securities. In the early years, investments are made very selectively, and not enough time has elapsed for defaults to fully develop. It is when an approach becomes applied on a broader scale and over a longer time that the true risks become apparent. That has not happened yet with peer-to-peer lending.
2. Underwriting standards are important
If you are going to make these loans, think like a banker. Get a written description of how people qualify for the loans you are funding, and how those standards are enforced.
3. So is the go-between
Since your money is going to pass through whoever is organizing these loan pools, you need to know whether they can be trusted and what their cut of the profit is.
4. A diversified borrower pool is essential
This is a key, because the more concentrated that pool is, the more exposed you are to suffering big losses due to a few defaults. Shoot for a borrower pool that is diversified not just in numbers, but in the geographic distribution of the borrowers. This way, an employment setback in one area does not disproportionately impact you.
5. You can manage risk by choosing different terms
All things being equal, shorter-term loans are viewed as less risky than longer-term ones. So, even though long-term loans may offer a higher yield, you can moderate your risk with a pool of high-turnover, short-term loans.
6. Not all repayment flows work the same way
In a loan pool, repayments can be structured in different ways. The most straightforward is for all investors to get paid at the same time as interest payments come in, but there are more complex structures that divide repayment into tranches. Later tranches -- in other words, lower priority repayments -- may offer higher yields, but these are the most susceptible to defaults.
If you venture into peer-to-peer lending, do so cautiously and with a limited amount of your investment assets. Don't let a few successes make you overconfident either, because default rates tend to soar during economic downturns. With that in mind, pay close attention to employment trends. If you see unemployment start to rise, it could be a good signal to back away from peer-to-peer lending.
Peer-to-peer lending can be a sensible investment for those who understand the risks. But the first thing to understand about those risks is that peer-to-peer lending is not a substitute for highly secure income vehicles like savings accounts and Treasury bonds.
This article originally appeared on Money-Rates.com.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.