By far the most common question I get from readers as well as friends and family is 'Are peer to peer loans safe?'
Here are 5 things to tell your grandma about how and why it is safe to invest in this new asset.
#1 This is what banks used to do
Lending people money for various things other than houses and lending to small businesses to buy a new piece of equipment or give them a credit line for short term fluctuations in cash used to be commonplace at banks. Now it isn't. If banks were doing it, then the need for a peer to peer lending industry would go away. The banks aren't so there is and there will continue to be a need that peer to peer lending is filling.
#2 The law of large numbers
The way insurance companies make money is that they bet on the law of large numbers. The law of large numbers says that most people won't get sick at the same time (for health insurance) and that most people won't die at the same time (for life insurance). Insurance companies bet that people won't die or get too sick and they win that bet year after year. Term insurance is issued specifically with this mind, after all it's a bet that you won't die in 20 years or whatever the term is, and most of the time you don't so the insurer keeps all of that premium paid.
According to the Federal Reserve, credit cards issued by the top 100 banks had a 3.87% default rate. This means that 96.13% are still in good standing even if some of those are late paying. This is the law of large numbers at work for credit card companies. The overwhelming percentage of people pay the overwhelming percentage of their bills the overwhelming percentage of the time. Grandma already knows this even if she didn't know this law had a name.
According to the Consumer Literacy report for 2012, a survey by the National Foundation for Credit Counseling, in the year 2012, 67% of Americans paid all of their bills on time. Now we know that of the 33% that didn't, that does not mean that they paid none of their bills at all, likely most were on time and some were late. Still, in our present slow growth environment, we still have the majority of people paying all their bills on time.
#3 Prosper and Lending Club are getting financially healthier every year
Both Prosper and Lending Club have gotten financially healthier in 2013 with outside investments from venture capital and private equity groups. The financial health of the platforms is important in answering the question of what happens to us and our loans if the platform itself goes bankrupt?
In September 2013, Prosper raised $25 million from Sequoia Capital and BlackRock. BlackRock is the world's largest asset management firm and Sequoia has long experience in working with tech companies like Apple, Oracle and LinkedIn.
Not to be outdone, Lending Club in May 2013, got a $100 million investment from Google's investment arm, Google Ventures.
Grandma would say just because others like it and invest in it doesn't make it safe, and she's right. However, the most likely way one of these lending platforms would go out of business is related to an unexpected drain of cash or actually running out of money. The cash infusion provided by these investments lessens the chances of this significantly.
#4 Social/Community Lending used to be the most common form of lending
When the US was a mostly agricultural based society, there wasn't a CitiBank or Bank of America on every corner. Many small farming towns did not even have a bank, but they did have co-ops (co-operatives). A farmer's co-op was a group of farmers that banded together and helped each other. They would pool their funds when a farmer needed a new piece of equipment to increase his crop yield and he would pay back the co-operative so that money would be available for the next guy. It was real true community lending where neighbors would help neighbors.
Now I do not exclusively look for loans in my city (Atlanta) or my state (GA), but I do have one loan from someone local and I like the idea that I am helping them. If this community lending idea is something that appeals to you, you certainly can set your own filters to only lending your money in your own state.
#5 Peer to Peer loans are almost exclusively for those with good credit already
Grandma has seen lots of changes in her lifetime. She may have lived through the Great Depression like my grandma did. She has seen America go from a no cash available society (during the depression) to war and economic booms with a cash based society to emerge as the credit based society that we are now. In order to be financially successful in America, you have to have access to credit. Prosper's minimum credit score requirement is 640 and Lending Club's is 660. Most borrowers, however, have outstanding credit like 720 or 750 or higher.
Grandma would say to this that just because they have paid their bills on time before does not mean they will now, and of course she's right. What we do know is that if people are in the habit of paying their bills on time and they don't see a big drop in Income or increase in Expenses, then they are likely to keep doing so. They will be part of the 67% who pays all of their bills on time every month. We can also be assured that those that already have good credit are some of the ones who best understand the importance of having and maintaining good credit, something they can influence directly with their continued repayments.
There is heavy investor interest in peer to peer lending now and we have even seen a securitization of peer to peer loans and one is in the works for SoFi, the student loan peer lending site. We shouldn't invest just cause it's cool though and it's becoming mainstream. We should invest because it is helping out our fellow citizens who are most likely paying all their bills on time already and already have good credit. We get to be the bank and if we get to help people stick it to their credit card companies, then that is just an added bonus. So these are 5 things you can tell your grandma about peer to peer lending and why it is a safe investment of some of your money.