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P2P Investing: How It Works


There's money to be made, but only if you're comfortable with risk.

Peer-to-peer financing seems to pose few risks for borrowers, but on the lender side it's best to do your homework and spread out the risk. The whole concept of social investing is warm and fuzzy -- making money while doing good -- but that's no reason to forget your investment objectives and get swept away by a borrower's compelling personal story.

Lending Club, one of several P2P sites out there, imposes stringent requirements for its borrowers, and says none of its best grade A1 loans have defaulted to date. According to an analysis from Javelin Strategy & Research, average net annualized investor returns on the site have been more than 9% since June 2007.

Lending Club assigns loans to one of 35 different classes. Higher-risk loans get the highest interest rates. Delinquent borrowers are subject to a "First strike, you're out" rule and can't borrow again until payments are brought up-to-date for six months.

Investors tend to spread their money across a broad portfolio in increments as small as $25. They can browse loan listings or, in the case of Lending Club, use a "Lending Match" tool to analyze which loans they want to fund. Investors profit if borrowers steadily repay loans. Lenders can hold loan notes until they are paid off or put them up for sale through a note trading platform. There are minimum income hurdles prospective lenders must meet.

"With P2P you have eliminated the analyst or fund manager you would otherwise have with other kinds of investments (by eliminating the middleman, you are also eliminating almost all investment fees -- a very attractive benefit)," says Barbara Bryn Klare, who covers P2P lending for in San Francisco.

"At both Prosper and Lending Club, you can invest in P2P notes individually, invest in a pre-set portfolio plan, or trade notes in a secondary market. I am hearing very positive feedback both on returns (especially in contrast to the volatile stock market), and customer service overall," she says.

But remember, none of the loans are secured, so as the economy goes, so could go the borrower. Lender beware.

Prosper was blasted as a poor investment vehicle in a recent story on The Big Money.

The company requested a retraction and said the story was misleading because the rates cited referred to early sub-prime loans it no longer allows. Prosper now requires a FICO score of at least 640. (See the latest marketplace performance here.)

Search the Web and you'll find plenty of blogs featuring anecdotes from people who have hands-on experience with P2P lending. One blogger says his Lending Club investment portfolio is earning a 15% annual rate of return. A blogger for "Moolanomy" also has some basic wisdom to impart.

Read more about the current state of credit here.
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