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4 Tips for Investing with P2P Loans

Miranda Marquit

One investing strategy getting a lot of play lately is the person-to-person (P2P) loan. While there are consumers who have found success using P2P loans to consolidate debt and get financing for various projects, it's also worth looking at the other side to that coin: the lender.

A savvy investor can add P2P loans to his or her portfolio and see reasonable returns. As P2P loans become more mainstream, they will be seen as a viable addition to more portfolios. Google recently made a $125 million investment in Lending Club, which indicates that the company is likely here to stay. And the other P2P lending giant, Prosper, also seems to be doing fairly well.

I've been investing in P2P lending for a few years, and my annualized return is right around 5.09 percent. I have a fairly conservative portfolio, so that's not too shabby. It may not beat stocks over time, but it has a good chance of beating bonds -- and definitely beating cash.

If you are interested in investing with P2P loans, here are 4 tips to help you improve your chances of success:

1. Research the Notes

The first step is to research the notes available. As with any investment, you want to understand how P2P lending works and do your due diligence before you take the plunge. Start by reading the borrower's profile, and purpose for the loan. Some borrowers don't share many details about the loan, or why they are borrowing. This can be a red flag. Instead, invest in notes from borrowers who have more to say. Do they state the reasons for their loans? (Debt consolidation is the most common.) Is there an explanation of how the borrower plans to repay the loan? And, if there is bad credit involved, are there extenuating circumstances?

2. You Can Hold P2P Notes in Your IRA

One of the great things about P2P lending is it is possible to hold notes in your individual retirement account. You will need to check with your current custodian about whether or not P2P loans are an option for your IRA. If not, you can open a self-directed IRA with a custodian willing to allow you to hold P2P notes. Additionally, some P2P lending sites actually offer IRAs. That makes it a little easier to enjoy tax-deferred or tax-free returns on your P2P investments.

3. Reinvest Your Money

Get more from your portfolio by reinvesting your gains. As borrowers repay their loans, your account grows. When you reach the minimum threshold to invest in a new note (usually $25), you are often alerted. You can then log in to your account and either withdraw the money, or reinvest it. I like to reinvest my returns. It allows the income I receive to be put back to work on my behalf. This can help you improve your returns overall, and build your portfolio at a rapid rate. Over time, as you have more to invest in notes, you can actually use P2P loans as part of your income investing strategy.

4. Don't Just Stick to "A" Rated Borrowers

P2P lending sites rate borrowers according to their credit. The higher the credit rating (usually on a scale of A to F, with A the highest), the lower the return you can receive. The theory, as with any other loan or investment, is that the lower the risk, the lower the interest rate. If you want the potential for higher returns, you need to invest further down the list.

I have been taking my expansion beyond A-rated credit slowly. I have invested in notes from those with B and C credit, and once I invested in a note from someone with E credit (there was a compelling story in the profile). However, I know those who balance their P2P lending portfolios by investing half in those with A-rated credit, and the other half with those with D, E, and F ratings.

It's worth noting, however, that the only charge-off I've had in my years of P2P investing has been by someone with A-rated credit. It can be worth it to take a little more risk in order to see the potential of higher returns. P2P lending can be a way to boost your investment returns, and diversify your portfolio. Just remember that you are loaning money, and there is the potential for default.

Miranda is a freelance journalist specializing in beginning investment option, personal finance, and entrepreneurship. Her work has appeared in numerous publications online and offline. Miranda's blog is Planting Money Seeds.

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