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Ask Farnoosh: Should I Lend Money to Strangers?

This week Farnoosh answers readers’ questions about the investment value of peer-to-peer lending and financing a second family car.

@nybigtimer tweets: I’m 27 years old. I have all the necessary financial documents, emergency fund, college fund for my children, Roth IRA maxed, several individual stocks, ETFs and mutual funds. I’m looking for a new type of investment. Is Lending Club a good idea?

If you do, as you say, have all your financial ducks in a row, then it may be worth exploring alternative investments including peer-to-peer loans as offered by Lending Club and Prosper. “Studies by professionals at Bloomberg into a considerable number of individual portfolios of peer-to-peer lending have so far shown that these could potentially become a new asset class,” says Robert Lamb, a professor of finance at New York University’s Stern School of Business.

With peer-to-peer (or P2P) loans you lend money to people who are seeking financing for everything from a house or car, launching a business, paying off credit cards, debt consolidation or paying for education. Lenders can choose from thousands of listings and review borrowers’ credit ratings before determining which ones they’d like to pursue. The lower the rating is, the higher the risk and potential rate of return.

In general, the return you’ll receive is relatively higher than what you’ll earn investing short-term in the broader stock market. At Prosper, for example, the average return on loans originated between July 2009 and November 2011, as of Sept. 30, 2012, was roughly 9.7% across all types of loans. It was as high as 14% for loans with the poorest credit ratings. So if you can stomach the uncertainty of lending your dollars to strangers – some of them no-so-creditworthy – it can pay off.
 
That said, not all loans are paid back. The loss rate at Prosper, for example, is a little more than 7%. These sites do also charge lenders a service fee (usually 1% annually), which takes a bite out of your total return. So as with all alternative investments, you want to make sure that whatever money you play with, you’re fine to part with.

Nikeya emails: We are in need of a new car, but worried that buying a second car this year will hurt us obtaining a mortgage. (We currently have a car payment for my husband’s vehicle, too). We are a military family and will be moving again next year to our last duty station and would like to purchase a house there. How can we approach this situation to come out on the winning end? I work an hour away and we can’t be a one-car family for too long.

The challenge here is addressing a short-term need of financing a second car without disrupting a long-term goal of buying a home. To come out on the “winning end” as you say, I’d recommend choosing a used vehicle that carries a relatively small and easy-to-manage monthly financial burden. Remember, there’s a lot more to owning car than just the loan. There’s gas, maintenance and the unexpected flat tire. As an active military family, you may qualify for a military car loan, which tends to have a lower interest rate and requires a smaller down payment compared to a traditional car loan. Some military loan providers include USAA, Navy Federal and Miles.

But before applying for any financing, assess your real need for a vehicle. Will you need a car after you move next year to your last duty station? Or can you get by on just one car after that? If all you need is a temporary car to carry you through the current year, you may be better off in the long run by renting a used car, as it won’t sink you further into debt. Some car rental agencies like Budget, Enterprise and Avis offer discounted rates for month-to-month rentals. “The monthly amount may still be higher than [financing] a new car, but there is no down payment and it’s only for one year,” says Thomas Pinkowish, president of Community Lending Associates

As for preparing to buy a home in the coming years, again, you’ll have access to easier financing as a military family through VA home loans, but you’ll still need to show that your debt is under control. “A basic and really important factor [of qualifying for a home loan] is debt-to-income ratio. Lenders will look at all your debt compared to your income. An acceptable ratio is capped at about 45% for most lenders,” says Shashank Shekhar, a mortgage lending expert and author of “First Time Home Buying 101.”

Got a question for Farnoosh? You can reach her on Twitter @Farnoosh or email her at farnooshfinfit@yahoo.com.

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