Play Banker to Your Peers

Peer-to-peer lending lets you reap the benefits of being a financier, though you'll also have to stomach the risks.

Your bank makes money off borrowers. Now you have the opportunity to do the same.

One of today's hottest investments, peer-to-peer lending, involves making loans to strangers over the Internet and counting on them to pay you back with interest.

The concept may be a bit wacky, but the returns reported by sites specializing in this transaction -- from 7% to 14% -- are nothing to scoff at.

No wonder the two biggest P2P sites are growing like gangbusters. With Wall Street firms and pension funds pouring in money as well, Lending Club is on track to issue $2 billion of loans this year, nearly tripling business over last year.

Prosper recently handled nearly $50 million in loans in a month, a 300% increase since early 2012. "A few years ago I would have laughed at the idea that these sites would revolutionize banking," says Curtis Arnold, co-author of The Complete Idiot's Guide to Person-to-Person Lending. "They haven't yet, but I'm not laughing anymore." Here's what to know before opening your wallet:

How P2P works: To start investing, you simply transfer money to an account on one of the sites, then pick loans to fund.

When Prosper launched in 2006, borrowers were urged to write in personal stories. Nowadays the process is more formal: Lenders mainly use matching tools to select loans -- either one by one or in a bundle -- based on criteria like credit rating or desired return. (Most borrowers are looking to refi credit card debt anyway.)

Loans are in three- and five-year terms. And the sites both use a default investment of $25, though you can opt to fund more of any given loan. Pricing is based on risk, so loans to borrowers with the worst credit offer the best interest rates.

Once a loan is fully funded, you'll get monthly payments in your account -- principal plus interest, less a 1% fee. Keep in mind that interest is taxable at your income tax rate, though you can opt to direct the money to an IRA to defer taxes.

A few hurdles: First, not every state permits individuals to lend. Lending Club is open to lenders in 27 states; Prosper is in 30 states plus D.C.

Even if you are able to participate, you might have trouble finding loans because of the recent influx of institutional investors.

"Depending on how much you're looking to invest and how specific you are about the characteristics, it can take up to a few weeks to deploy money in my experience," says Marc Prosser, publisher of LearnBonds.com and a Lending Club investor.

What risks you face: For the average-risk loan on Lending Club, returns recently averaged 8% to 9%, with a default rate of 3.5% to 4%. By contrast, junk bonds, which had a similar default rate this year, were yielding 6%.

But P2P default rates apply only to the past few years, when the economy has been on an upswing; should it falter, the percentage of defaults could rise dramatically, says Joanna Pratt, VP of investing for consumer finance site Nerdwallet.com.

In 2009, for example, Prosper's default rate hit almost 30% (though its rate is now similar to Lending Club's). Moreover, adds Colorado Springs financial planner Allan Roth, "A peer loan is unsecured. If it defaults, your money is gone."

Some consumer advocates also think the industry needs more regulation.

How to do it right: Spread your bets. Lending Club and Prosper both urge investors to diversify as much as possible. Pratt agrees: "Resist the urge to put all of your eggs in one basket." The graphic at bottom shows how investing in more loans reduces your risk.

Stick to higher quality. Should the economy turn, the lowest-grade loans will likely see the largest spike in defaults, so it's better to stay in the middle to upper range -- lower A to C on the sites' rating scales. (The highest A loans often don't pay much more than safer options.)

Stay small. Until P2P lending is more time-tested, says Roth, it's best to limit your investment to less than 5% of your total portfolio. "Don't bank the future of your family on this," he adds.