Funding loans through peer-to-peer lending companies such as Prosper or Lending Club are becoming an increasingly popular alternative investment, but many investors fund loans to borrowers that are likely higher credit risks than you should be willing to put any of your lending dollars in.
Peer-to-peer lending companies use a person’s credit score as the primary gage of whether or not someone should qualify for a loan and at what interest rate they should qualify for a loan at. However, there’s a lot more than someone’s credit score that you should look at when evaluating a loan.
The first thing that investors should ask themselves about the potential borrower, is “Does this person have the ability to repay their loan?” A good way to determine this is based on their employment information. How long has this person worked at their current job? Is the person working in an industry that’s stable? Borrowers that work for state and federal governments are generally a lower risk because their jobs will still be there even if the economy isn’t doing well.
If you’re asking yourself, “Why would this person take out a loan for that?” it’s probably not the loan you want to fund. For example, we recently read a Lending Club loan listing on another website where a borrower wanted money to develop software that would perform some sort of arbitrage on Forex currency exchanges.
You should also look at the language the person is using in their loan listing and in their responses to borrower questions. Ask yourself, “Does this person sound like they have a good handle on their financial situation?”
Although we don’t have any evidence, we would wager that listings that are filled with poor-spelling, grammatical errors and an ill defined need for a loan will likely result in much higher default rates than borrowers that can clearly and effectively communicate their need for a loan.
We also tend to avoid certain types of loans are have a higher-risk simply on a common-sense basis. For example, we know that 50% of businesses fail within the first three years of operation. If a business is looking for a loan on Lending Club, it probably means they are struggling or are unable to get capital from traditional sources. We don’t know about you, but that’s not the type of loan we would like to fund!
