As Peer-to-Peer Lending Grows Up, Investors Seeking High Returns, Safer Bets Jump In

If a stranger stopped you on the sidewalk and offered to pay you a 10% interest rate if you lent him or her $20,000 to pay off a credit card debt, would you do it? Many investors seeking greater returns outside of a volatile market are turning to such a concept by way of online peer to peer (P2P) lending. But, as with any investment opportunity, the hope of great returns requires risk. Here's the scoop on what the P2P market is all about, and whether it may be a worthy addition to your portfolio.

The fundamental concept of P2P lending predates the formalized banking and market structure entirely, but the online movement began around 2006 when Prosper, still one of the largest players in the space, opened its virtual doors to potential borrowers and investors. Soon after, LendingClub joined the scene. Years later, both venues continue to attract new investors searching for returns: Prospers' closed loans grew by more than 65% for the week ending September 26, 2012, compared to data for the same time period last year. LendingClub's closed loans have nearly tripled since September 2011, according to LendStats.com.

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The idea behind the trend is simple: connect would-be investors to borrowers who need money for purposes that run the gamut from paying off credit card debt, to funding home improvements, to starting a business. In some cases, P2P borrowers do have less than stellar credit, but many are very credit-worthy borrowers who simply haven't found a solution via traditional financing.

In a phone interview, LendingClub Chief Marketing Officer Scott Sanborn described his site's average borrower: average FICO score of 716, aged early to mid thirties, individual income of $69,000, and an established credit history of about 12 to 14 years. He says that as many of 70% of LendingClub borrowers are seeking loans in order to pay off high interest credit card balances that they racked up in their younger years.

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To validate that borrowers' claims are fact, both sites require the completion of online loan applications and access to credit bureau information. Additionally, Sanborn explains that LendingClub's process includes manual underwriting, and results in less than 10% of approved loan applications. He adds that 60% of loan applications are "flagged" for further verification, which may include requiring proof of income, or similar information from the borrower. (Prosper also offers its own so-called "3 Step Verification" process, though the site did not respond to requests for comments on details of the process by press time).

Such stringent verification and subsequent transparency is likely what has prompted so many investors to take a shot in the P2P lending market. On both sites, investors can scour for opportunity based on any number of factors, including site-determined risk grades, credit score, debt to income ratio, borrower history, and reason for the loan request, among other factors. While there's always the potential to lose money from borrower default, both LendingClub and Prosper offer a collections process (at the expense of the investor), which may or may not result in recovered funds. In the case of Lending Club, Sanborn points out that because funds are deposited directly in an investor's account when payment is made, intervention around potential payment default can occur as early as day one. Perhaps the main draw behind P2P lending is the risk management opportunity that a diverse sea of borrowers provides: The success rate behind P2P lending is not usually about loaning to one person, but rather, creating a diversified portfolio by loaning to many borrowers. Though investors run the gamut from small investors who put forth as little as $25, to institutional investors, the concept is about spreading bets. "No one who has invested [with LendingClub] in 800 notes or more (which can be done with as little as a $20,000 investment), has ever lost money -- regardless of strategy or timing," says Sanborn.

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Jane Boon of New York City, NY, is a self-described "early adopter" of P2P lending via Prosper. Though she lost about 5% on her investment in the pioneer days of the P2P market, which she described as having "fewer rules guiding borrowers and lenders," she's currently experienced favorable returns of about 13%, which she credits to the Proper's "new lending format and improved visibility into borrower background." Boon says she seeks borrowers based on criteria like those who already successfully borrowed (and paid) on a peer-to-peer platform, borrowers who have also been P2P investors, those risk-graded B, C, or D and who earn more than $50,000, and those with a favorable history regarding delinquencies and debt-to-income ratio. She also favors borrowers in certain professions, including military officers and scientists who she says tend to "have low rates of default on Prosper."

Investor style is varied on the P2P platform: Some investors, like Boon, prefer to analyze the site-provided data to develop their own strategies for identifying what Sanborn calls "pockets of opportunity." Others mine borrower data to spot trends at a much deeper level, and some are content to yield lower returns by lending only to "grade A" investors.

Why do investors trust the methodology behind the rating risk scores P2P sites assign? The credibility factor behind the P2P market is heightened by the impressive leadership teams both sites boast. For example, Prosper is led by financial services and technology executives with roots at the Charles Schwab Corporation (SCHW) and Capital One Financial Corporation (COF). In addition to expanding its stable of institutional investors, Lending Club's leadership also includes decision-makers like John Mack, former Chairman of the Board of Morgan Stanley (MS).

Strangers on the street look a lot more trustworthy with such executives standing behind them.