When I think about lending money to friends and family, I cringe a little.

After all, lending to “regular” people you know is fraught with emotional pitfalls as well as the possibility that you won’t ever get your money back. And you usually don’t even earn interest on such loans.

I’d much rather lend money to strangers — and I do. You might wonder: How is that possible?

Banks lend money to strangers all the time, and they make a killing. Why can’t I stand in the place of a bank, allowing ordinary borrowers to pay interest to me? 

You don’t have to start your own bank to lend money to others. There’s a revolutionary way to earn returns that have the potential to beat the stock market (or at least bonds). It all hinges on your willingness to lend money to complete strangers. This method is known as peer-to-peer lending.

Over the past few years, I’ve invested a portion of my portfolio in peer-to-peer (P2P) loans. P2P lending sites such as Lending Club and Prosper match investors (lenders) with borrowers.#-ad_banner-#

As an investor, you have control over the types of loans you invest in. Each loan is divided up into $25 increments, called notes. So, if someone wants to borrow $2,500, 100 people can help fund that loan. Because you are only risking a small amount of money on each loan, if there is a default you aren’t affected as greatly.

If the borrower is fully funded (and to get any of the money, he or she has to be), the funds are disbursed and the borrower begins making payments. The P2P lending site figures out your portion of the principal and interest from each payment the borrower makes and deposits it in your account.

You can then choose to withdraw the money or reinvest it in other notes.

Now, when you invest in P2P loans, you need to do your research — just as you would with any other investment. Many P2P investors start out by sorting notes by credit rating. All borrowers are assigned a credit “grade,” with “A” as the best credit and “F” or “G” as the worst. Someone with good credit pays a lower interest rate, so you earn less on your investment. When you invest in a note with a higher potential return, you are investing in someone with poorer credit; the default risk is considered greater.

As with other investments, the higher the potential returns, the greater the risk. Most of my notes are invested in loans initiated by those with “B” credit, although I also have some with “C,” “D,” or “E” credit. I have also invested in those with “A” credit. Interestingly, most of the write-offs I have are those with “A” credit. It’s one of the reasons I started shifting more of my notes to those with “B” credit.

While credit ratings can help determine whether or not a borrower represents an acceptable risk, it isn’t everything.

You should also read the stories associated with the borrowers. Look for borrowers who share the purpose of their loans and can articulate a plan for repaying the loan. I like to invest in notes from borrowers who plan to use the money to start businesses. I also occasionally invest in those consolidating relatively small amounts of debt; I consider large debt consolidation loans riskier — even if the borrower has “A” credit.

It makes sense to compose a P2P lending portfolio with a range of credit ratings, depending on your risk profile.

Adding a portion of higher-risk notes to your P2P asset allocation can boost your overall returns, while lower-risk notes can provide you with a degree of stability.

Through the economic downturn and the stock market difficulties following the financial crash, my P2P loans handily beat the stock market. My annualized returns haven’t beaten the stock market this year, but they are still respectable, and they certainly beat bonds and cash.

The 10-year Treasury yield stands at 2.8%; the three-year (a common term length for P2P loans) Treasury yield is currently 0.8%. Compare that to the current return cited by Lending Club for an “A” loan: 7.6%. If you are willing to take risk on someone with “C” credit, the potential return jumps to 15.2%. If you’re ready to give someone with “F” credit a chance, you could see potential returns of 22.6%. But, even though that kind of return is likely to put stars in your eyes, remember that your risk of default is higher.

Investing in P2P loans, like any other investing, comes with risks, and the most obvious is the possibility of default. Another risk, though, is the illiquid nature of the loans. You can’t just sell your notes like you can stocks or shares in mutual funds. You have to wait until enough of your loans start paying out before you can even think of withdrawing money. If you invest in P2P loans, be aware that you will be locking in your money for an extended period of time.

Action to Take –> P2P loans offer an interesting way to diversify your investments. You can even hold P2P loans in an IRA. Sign up with a well-known site like Prosper or Lending Club, and you can start earning reasonable returns by lending money to ordinary people.

This article originally appeared at InvestingAnswers.com
Earn Up To 20% By Acting Like A Banker

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