When looking to invest or generate income with peer-to-peer lending, it is important to consider what your goals are and what part this money plays in your overall financial situation. Understanding what you have in mind for this money can help you then determine how much money you should have in the peer-to-peer marketplace.
Prosper Lending as an Asset Class
In order to fully understand the role that this type of money plays, you first have to understand how it works as an asset class. The most common types of assets are:
- Real Estate
Sure, there are other derivatives of asset types, but these are the four most common types of assets that make up a typical person’s portfolio. So, where does peer-to-peer lending fit in?
When you lend money to someone on Prosper, it is essentially the same as buying a bond. A bond is defined as: “A certificate of ownership of a specified portion of a debt due to be paid by a government, individual, or corporation to an individual holder, usually bearing a fixed rate of interest.”
For example, when you buy a U.S. Savings Bond, you are lending money to the government, and in return they agree to repay you over a specified amount of time plus a specific amount of interest. The same transaction happens in peer-to-peer lending-only the agreement is between two individuals.
Comparing Prosper Loans and Bond Risk
All bonds are not created equal, and depending on the issuer, a bond may carry more or less risk than another bond. Take government bonds for example. These are considered the safest of all bonds because repayment is backed by the full faith and credit of the government. This security comes at a price-lower interest rates.
Then consider corporate bonds. These are companies seeking loans from investors. Since the repayment generally isn’t guaranteed, they typically command a higher interest rate to attract lenders. Very large and stable corporations will typically have lower interest rates, whereas very small or financially insecure companies may offer very high interest rates because the possibility of defaulting on the bond is much higher.
Prosper loans are no different. The higher the risk of default, typically the higher the interest rate you can receive. If you are interested in funding a Prosper loan to someone with a poor credit rating, relatively high debt-to-income ratio and a 21% interest rate, you have to realize that this is no different than buying a bond from a small start-up internet company that has a chance of failing. With the higher rate comes added risk.
Where This Fits Into Your Portfolio
Now that we’ve determined that peer-to-peer loans are nothing more than personal bonds, where do they fit into your portfolio? To answer that, it comes down to what your goal for this money is. Do you want to generate regular income that you can use today? Do you want to simply generate income so that you can place the money into more Prosper loans? Or is this all part of the bigger picture where you’re looking to simply accumulate more money for long-term goals such as retirement?
For short-term income you can focus more on diversifying across different Prosper loans and cash you may have elsewhere compared to how it fits within your overall portfolio. Short-term goals can put this money at risk, but you are doing so knowing that it is money you can afford to possibly lose or earn less since it isn’t being used to fund something like retirement.
Here you want to focus developing a good mix of loans and cash that produces the highest reward with least amount of risk. As far as how much money you should be putting into this practice, you really just want to make sure that you are comfortable with the amount of funds you have committed and that tying this money up isn’t sacrificing your other long-term goal funding.
When P2P lending with a long-term focus, things are a little bit different. Since this money makes up part of your portfolio that shares a similar goal, you want to make sure they work together and you keep your risk/reward balance in-check.
You may have heard about typical asset allocations before that are based on age and risk-tolerance-90/10 mix of stocks and bonds, 70/30, 30/70, and so on. Conventional wisdom suggests that the younger you are, the more aggressive you can be with stocks because you have more time to recover from losses and see higher long-term average returns. As you age and approach retirement, you generally move to a more conservative approach that protects principal since you likely are or will be living off of that money.
Comparing Prosper loans to bonds is only a start, because you first need to know what type of bonds you’re dealing with. Remember, most of the asset allocation models consider the bond portion as a very conservative bond position that consists of primarily government bonds for guaranteed principal. When lending money on Prosper, you aren’t getting a guarantee that the government will pay you back, so these loans are much more like corporate bonds where there is a varying degree of risk.
That being said, does this mean if you consider yourself someone who should be in a 90% stock and 10% bond portfolio that you should allocate 10% of your assets to Prosper? Not exactly. Remember, in a typical asset allocation strategy, the bond holdings are used to safeguard your stock declines with protection of principal and interest payments. Thinking about corporate bonds and Prosper loans is closer to comparing them to stocks in this regard.
So, if you have a $100,000 long-term portfolio that is appropriately invested in 75% stocks and 25% bonds, what would be reasonable as a peer-to-peer lending allocation? If you’re seeking low-quality loans and trying to obtain the highest interest rates, your peer-to-peer lending holdings should be treated more like stock. This means that of your $75,000 in stocks, you should either sell some of the stock position to put in Prosper, or if adding new money, treat it as purchasing new stock and adjust your bond holdings appropriately.
If you are being much more conservative with your Prosper lending and seeking only the highest grade loans, you have a bit more flexibility. While even the highest rated borrowers aren’t guaranteed to repay the loan, the likelihood is much higher. For the most part, you can probably be fairly comfortable in considering this money as part of the bond portion of your portfolio.
Ultimately, your financial portfolio is more of an art than science. There are no rules that are set in stone, and it is up to you to determine how much risk you’re willing to take. Lending money on Prosper is a great way to add diversification to your portfolio, but you do need to understand how this money fits into your financial picture. Different goals will determine how much money you should allocate towards peer-to-peer lending and the amount of risk you should take.
Jeremy is the author of the personal finance blog Generation X Finance, which aims to help a unique generation achieve financial independence. Jeremy also writes for the Financial Planning topic over at About.com. He currently works as a retirement plan specialist with a focus on employer-sponsored plans.