Are Marketplace Loans a Good Investment Alternative?

In the wake of the financial crisis in 2008, the consumer credit market completely dried up. Banks were unwilling or unable to lend and borrowers had very few options when they needed loans.

This unique situation spawned a whole new breed of lenders. Initially, these lenders were referred to as peer-to-peer or “P2P” lenders. Today, they prefer the term “marketplace lenders.” Companies like Prosper Marketplace and LendingClub Corp. (ticker: LC) branded themselves as high-tech alternatives to traditional bank lenders, and their timing couldn’t have been better.

In just over a decade since its founding, Lending Club has already funded nearly $25 billion in loans.

Borrowers come to Lending Club looking for personal loans to use for anything from debt consolidation to weddings to home improvements. To receive a marketplace loan, borrowers first fill out an application that includes a number of questions about personal financial information. Lending Club then assesses the risk associated with the loan and assigns an interest rate. Finally, the loan is added to Lending Club’s marketplace, and investors can invest in the loans.

Investors receive payments from the borrowers on the loan and interest on the principle. Lending Club receives a small fee.

For investors, marketplace loans such as the ones found on Lending Club’s platform offer tempting returns, especially with interest rates still at historically low levels. Even after the Federal Reserve recently issued its second interest rate hike in four months, the national average interest rate on a two-year certificate of deposit is still only 1.45 percent, according to Bankrate.

At the same time, Lending Club advertises historical annual returns in the 5 to 7 percent range for marketplace loan investors. Even for its lowest-risk A-graded loans, Lending Club reports a historical adjusted net annualized investor return of 5 percent.

The investor returns on these marketplace loans are so appealing that it’s easy to see how potential investors could be skeptical.

David Blake, director of the pension institute at the Cass Business School in London, says the biggest potential risk lies in the loan rating process.

“My understanding from similar peer-to-peer loans in the U.K. is that in the early days the loans were self-selected as being good quality (they were genuinely good ideas, but could not get standard bank funding). But over time the quality fell, and no one was really doing the credit rating properly,” Blake says. “I would not recommend this for retail customers who are not in a position to assess the loans themselves.

People who invest in Lending Club loans are reaping the rewards of the company’s cost savings relative to traditional lenders.

“We leverage technology and a marketplace model which enables us to operate more cost efficiently and deliver solid risk-adjusted returns to investors, and that advantage will remain irrespective of the rate environment,” says Sid Jajodia, Lending Club’s chief investment officer. “Additionally, consumer credit is an asset class that has traditionally delivered strong returns regardless of the interest rate environment.”

Jajodia says Lending Club helped “democratize access” to consumer credit.

“Lending Club assigns a grade from ‘A’ to ‘G’ to each loan based on assessing the credit quality and risk attributes of the borrower,” he says. “The lowest interest rates are assigned to the least risky grades, which reflect the potentially lower loss rates and lower volatility of returns.”

According to Lending Club’s website, the company’s loan grading formula incorporates an applicant’s credit score along with “a combination of several indicators of credit risk from the credit report and loan application.” However, the website does not explicitly state the formula the company uses and the variables it takes into account.

Without those details, Blake says there are simply too many unknowns to consider marketplace loans anything more than a speculative investment. “The usual adage applies here: if it looks too good to be true, it is too good to be true,” he says.

Mark Hebner, CEO of wealth advisory firm Index Fund Advisors, says there are better options out there for investors. “There is no reason to invest in an unknown risk and expected return of 5 to 9 percent when you have 89 years of the S&P 500 earning a 9.5 percent return,” Hebner says.

In fact, since 1926, the rolling 30-year annual return of the Standard & Poor’s 500 index has stayed between 8 and 15 percent.

But just because there is a certain amount of risk associated with a marketplace loan investment doesn’t necessarily mean there is no opportunity for investors.

“The big picture is that there is no free lunch and that higher returns are typically associated with higher risk,” says Brad McMillan, chief investment officer for Commonwealth Financial Network. “On the other hand, with lower costs for seeking financing through this channel and a wider range of potential loans, this can offer a real opportunity to match both companies and investors in a way that just isn’t possible through traditional channels. So the opportunity can be real.”

Marketplace loans provide investors with the opportunity for much higher returns than CDs or treasury bonds. A portfolio of marketplace loans can serve…

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