CD Investment Alternative -- Peer-to-Peer lending
Returns on cash are getting hit hard as interest rates decline seemingly every week. With the explosion of the internet age, a new investment opportunity called peer-to-peer lending has emerged that offers a compelling alternative to investing in CD's, savings accounts, and money market funds.
What is Peer-to-Peer Lending?
Peer-to-peer lending enables individuals to lend money to ordinary people seeking loans (usually unsecured) without the use of a financial intermediary, or middleman, such as a bank. The internet, with its inherent ability to enable masses of people to organize activities online, has been the prime factor in the growth of peer-to-peer lending in the U.S..
In the traditional banking system, banks "buy" your money for the rate they pay you on your checking, savings, and CD deposits (currently somewhere between 1-5%). They then "sell" your money as loans to borrowers at the going market rate for loans. The bank then takes the difference to cover its costs of operation and keeps the remainder as its profit.
In peer to peer lending, the Lender and Borrower cut out the bank as the middleman. This gives the borrower a chance at a lower interest rate on their loan as Lenders compete with each other to make loans to borrowers. Conversely the Lender often earns a higher interest rate on their cash as the bank share of the interest rate is cut out of the deal. Lenders can achieve returns of between 9 and 12%, depending on their risk tolerance.
The market for peer-to-peer loans is still relatively small but growing fast, according to Celent, a research firm. Celent projects that $5.8 billion in peer-to-peer loans will be made in the USA by 2010, an 800% leap from the amount in 2007.
The biggest player in the US peer-to-peer lending market, Prosper, has done over $130M in loan volume since their launch in 2006. For more, check out this recent BusinessWeek article on the Prosper experience.
Benefits to Lenders
- Lenders can earn a significantly higher return on their cash -often 9-12%- than they can with traditional bank instruments such as savings, checking, and money market funds.
- Peer to peer lending can give you more liquidity than CDs. Unlike CDs, where your cash is tied up for a set period of time, in peer-to-peer lending Lenders typically receive monthly payments of principal and interest.
Risks Associated with Peer-to-Peer Lending
- Loan principle is not guaranteed.
- Unlike deposits in a bank, peer to peer lending has no FDIC insurance.
- Default risk - As a lender you are assuming the risk that the people to whom you lend may not pay back their loan. It's wise to do your homework and diversify your lending over many loans to many different people to minimize your risk.
