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Why Peer-to-Peer Lending Could Be a Good Investment Choice

Why Peer-to-Peer Lending Could Be a Good Investment Choice
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Like most entrepreneurs, I'm a risk-taker. It took guts to quit my day job to start my own business. And it takes guts to keep at the business even when my income drops.

But when it's time to invest the money I've risked so much to earn, I like to play it safe. Most of my retirement money is in index funds and municipal bonds. I'll never earn spectacular returns this way, but I feel confident that I won't suffer catastrophic losses either.

Still, the entrepreneur in me is always looking for an opportunity to earn a greater return with reasonable risk. Recently I've become intrigued with the idea of investing some of my money in peer-to-peer (P2P) lending. P2P loans are unsecured personal loans made with the help of a third-party intermediary. The internet has made this practice much easier, with companies like Prosper and Lending Club matching borrowers to investors.

It turns out P2P lending isn't so scary. As an investor, you're not fully funding any loan; as a lender, you can specify how much risk you'll take.

Borrowers, who might need money to buy a car or pay off a credit card, complete an online application, and their creditworthiness determines the interest rate of any potential loan. (The interest rates offered are generally lower than those of credit cards.) The P2P companies then match the borrowers with lenders willing to risk funding the loan.

On the surface this sounds like a dubious way to invest. But it turns out P2P lending isn't so scary. For one thing, P2P companies help spread the risk. As an investor, you're not fully funding any loan; if somebody borrows, say, $2,500, then 100 investors might lend just $25 each. What's more, as a lender you can specify how much risk you'll take. If you're jittery, you can lend money only to borrowers with pristine credit. If you want better potential returns, you can lend to borrowers with less favorable credit histories.

What sorts of returns can you earn? Prosper touts an average seasoned return of 9.69 percent. (Since 2009, Prosper's lowest-risk investments have yielded 5.41 percent; the highest-risk loans have yielded 14.12 percent.) Lending Club says investors with 800 notes or more purchased directly through the company have earned 100 percent positive returns; 93 percent of those investors earned between 6 and 18 percent.

Sounds too good to be true, right? That's what I thought, so I spoke with Lending Club co-founder and CEO Renaud Laplanche and asked him to allay my fears. "We decline over 90 percent of the loan applications we receive," Laplanche says. "That's the price we pay to deliver predictable performance to investors."

Laplanche contends that P2P lending is less volatile than playing the stock market. But the cost for this kind of predictability is a lack of liquidity; you can't just pull your money out of P2P loans the way you might sell a stock or a mutual fund.

And the risks? "The main macroeconomic factor that has an impact is the unemployment rate," Laplanche says. "More specifically, the rate of job loss." In other words, if unemployment is up, borrower default rates increase, too, and investor returns decrease.

I haven't opened a P2P investment account yet, but I plan to invest a couple thousand dollars this year through Prosper or Lending Club. After all, I'm an entrepreneur. I'm willing to take calculated risks--especially if the potential returns are worth it.

This story appears in the February 2013 issue of Entrepreneur. Subscribe »