March 17, 2012
BY: Robert Hallberg, Topics: peer-to-peer lending
It wasnât too long ago since you could get a 5% return on your money with an online bank account and perhaps an additional 2% by locking your money into a CD. However, those days are now gone and the average interest rate in a regular savings account is well below 1%. Bonds are not much better with the S&P500 dividend yield sitting at 1.97%.
This is especially damaging for savers and retired people as inflation is several points above any traditional income generating instrument, making it impossible to find a return to be beat inflation, let alone making an income to live on.
Traditionally banks and savers have been working for mutual benefit. Savers put their money on deposit into a bank in exchange for interest and safekeeping. The banks then took this capital and lent it out to other borrowers including commercial businesses and consumers. They made a reasonable profit based on this model and were able to share more with their customers. But this model no longer seems to be working as the Fed is providing unlimited amounts of capital to banks at almost zero percent interest. And without strong demand for traditional bank deposits, from savers, banks are able to charge high interest rates to businesses and consumers while paying its lenders just a fraction, leaving the public holding the bag.
Despite low interest rates â set by central banks â the free market and technological advancements have solved this problem. The solution is based on a familiar technology called peer-to-peer lending which allows individuals to earn a higher return by cutting out banks and middlemen.
It may sound a little risky, making an unsecure loan to a stranger. Yet the number defaults are low with the vast majority of people paying their loans back on time. In addition, you can pick a loan according to certain risk categories based on the borrowerâs credit scores, debt-to-income ratios, and income verification, etc. The safest A-grade loans have a default rate as low as 1% while the highest yielding loans have about a 10% default rate.
But the really beauty with this system is that it allows you to diversity your loan portfolio. Rather than making a single loan of $10,000, you can slice it up into 200 loans with only a $50 risk per loan. This is the same model banks use to structure their loan portfolio and the result is usually a consistent and expected rate of return after fees and defaults.
More importantly this model puts you in charge. Playing the role as the banker you have the opportunity to create a customized portfolio according to your risk tolerance. The chart below shows examples of typical loan offerings from Prosper and Lending Club â the two largest peer-to-peer lending companies in the industry.
Lending club is the largest peer-to-peer lender by loan volume and makes $36 million in new loans each month and has a total of $500 million in outstanding loans. But its fast growing competitor, Prosper is not far behind with over $300 million in loans and 1,260,000 members. In addition, smaller startups like Lonio and LendFriend are entering the market in response to the growing demand for consumer credit.
Peer-to-peer lenders make money from collecting small fees from the borrower; typically in the range of 1-2% depending on the size of the loan. Compare this to the 7-9%, banks like to charge and you can see why these services have become so attractive.
What makes this a win-win for both the lender and borrower is the same concept that allows internet companies like Amazon and eBay to flourish. They can scale their operation over the internet without much overhead and without the need to maintain branch offices and staff to support their operations. What the internet has done to the music, movie, and retail industry is now being done to banking and the ultimate winner appears to be the consumer.
To learn about trends and spot the next investment opportunity read the Casey Report from Casey Research. It's a monthly investment news letter that breakdown economic trends in a way that is easy to understand. They make recommendations based on economic reality and their track record is several times better than the market or any mutual fund for that matter.
blog comments powered by Disqus