Handling Finances

No, this isn’t yet another ‘bash P2P lending’ writeup, I’m actually quite impressed with both the idea and the execution of Prosper.com and LendingClub.com. There are issues surrounding default rates that are really important, but in my opinion, it would be hard to do due diligence regarding the P2P lending and not have a reasonable understanding of default rates and how they’re affected.

The problem with P2P lending in my opinion is that the interest rates don’t quite work the same way as with money market accounts and as the lending sites don’t point it out, it’s very easy to miss. Quite simply, you only earn interest on the money that’s actually loaned out — as the loan is slowly repaid, you earn less and less unless you reinvest the money you receive in another loan.

For example, if you lend out $50 at Prosper and earn 8% interest on the loan, you’ll end up with $56.40 at the end of the three-year period.  Due to the magic of compound interest, you’d earn the same amount in a money-market account at 4.0%.  Why the big difference?  You’re not earning interest on any interest paid and you’re not earning interest on any principal paid.  In short, in a money market account, each interest payment immediately starts earning interest itself.  At Prosper, you have to reinvest — or make another loan to earn interest on the money that’s paid back to you.

It’s a simple concept, but something that often gets overlooked when people get into P2P lending.  Of course, if you reinvest the payments you get back every time you accumulate $50, your ‘losses’ are much lower.  In fact, if you have around $1600 invested, you’ll accumulate about $50 in payments each month, so on average, you’ll only lose about 0.1% due to money sitting around waiting for your next loan.

It’s not a problem that makes P2P lending worthless for lenders, but you should carefully consider the cost if you plan to invest less than a thousand dollars in P2P loans.  Not only will your returns be significantly slashed as a large percentage of your money sits doing nothing, you’ll have so few loans that even one default could easily wipe out your potential profits altogether.

This entry was posted on Monday, March 10th, 2008 at 2:57 pm and is filed under Debt, Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.