The mortgage crises and the big recession are still not fully behind us just yet. One of the very nice, but also very negative changes from these events were record low mortgage rates and interest rates. However, if you are an investor and wanted to add some bonds or savings certificates to your mix of investments looking for income from interest, you were pretty much screwed.
My wife and I put a lot of money into a money market for rainy days, but with interest rates heading down for so long that was a loss bringer due to inflation being higher than the interest we earned. So, I went looking for additional options and discovered micro-lending. There are 2 larger service providers that are active in this field. Prosper and Lending Club seem to be the most viable options when investing into micro loans.
So, how does this work at all? Prosper and Lending Club hand out loans to people that otherwise would have problems getting a loan from a bank as an example. These people either have less than stellar credit scores or the purpose for that loan is not supported by their bank. While Prosper and Lending Club charge high interest rates, it still seems to be a better alternative for many people. The interest rates are still lower than what a credit card company would be charging you.
On the investment side of things Prosper and Lending club take on external “investments” from people like you and me. So, if I wanted to invest into micro loans I can sign up with Prosper and Lending Club and then invest into individual loans. The keyword is “micro”. So, instead of investing a large amount of money into a single loan you rather spread out your risk and invest smaller amounts of money into many loans. Here is an example. I put $2,500 into Prosper so that I could invest into loans. Instead of putting my money into one single loan and risk losing it all if that loan goes belly up, I invested into 100 loans with $25 each. I am spreading out the risk across 100 loans. If – for whatever reason – a loan goes belly up my loss is limited to $25 per loan.
Prosper and Lending Club provide historic data about investments and loan failure rate. Based on that data you can spread out your risk across different risk levels and actually risk losing a few loans along the way and still get a double-digit ROI (Return on Investment). It’s a numbers game really. Statistical data shows that you will maybe lose 5% of your investment, but if you make 10%-15% in interest it totally makes up for the potential loss. Also, each loan is being repaid monthly – just like a regular loan. The person borrowing the money makes monthly payments until the loan is paid off in 1, 3, or 5 years. So, every month you collect interest on your investment + a fraction of your original investment is being repaid as well. In my opinion it is unlikely that a loan will go belly up within a few months after being initiated and so your real risk of losing that investment is reduced even more.
While Prosper and Lending Club seem to be reputable companies I would not advise to invest all your nest egg money into micro-loans. I see micro-loans as part of the mix when investing money. Invest into stocks, maybe some savings, money market, real estate, and micro loans as an example. Spread out the overall exposure to risk.
However, that being said I find it very interesting that there are people or companies who invest larger amounts of money into micro-loans. When I selected my loans to invest in, I could see the amount of money other people would put in. You do not see who these people are, but you see the same user/investor names over and over again. And these guys do not invest $25 per loan or $100 per loan. Often they invest $1,000 per loan. These guys really play with larger amounts of money, but the same idea applies. Spread out the risk by investing your money across many loans.
So far I have only invested $2,500, but my account value is already at over $2,600 for the year. I made my first investment in February. Now imagine I would have invested that money into a savings account or money market where the average interest rate is 0.25%. I am clearly ahead from an investment perspective. My current plan is to monitor this a bit more, but then I want to put more money into this type of investment. Eventually I am thinking of picking 2 dates per year where I transfer some money over and invest it. This will build up a nice portfolio over time and it will give me a good cash-flow so that I am not stuck inside these investments in case I need money. Again, it is a numbers game where you slowly ramp up the investment over time. I am also planning on spreading out my investments by using both Lending Club and Prosper.