Alternative to Paltry Money Market Yields

by Kirk Kinder on September 21, 2012

Admit it. You hate bankers. It’s ok – I admit it. Banks assume a massive amount of risk yielding enormous profits. When the risks implode, the banks get a bailout. How do they repay us? They give us sub-1% yields on our money. I am not saying all banks are bad. I love credit unions and community banks that avoided the dangerous tactics undertaken by the To Big to Fail Banks (TBTF). Over the next couple weeks, I am going to examine a few ways to kick those bankers to the curb without taking on loads of additional risk. If you are tired of earning pennies on your balances, these might be better ideas.

The first idea is peer-to-peer lending. Why would you want to look at peer-to-peer lending? Let’s face it. Banks are nothing more than glorified middlemen. They take your money and pay you a whopping sub-1% return. The banks take your money and loan it as mortgages, business loans, auto loans, and credit cards at substantially higher rates. You get 1% while the banks get 5% or more. Peer-to-peer lending cuts out the banks. You get a higher return while the borrower pays a lower rate than the banks charge.

I focus on two premier peer-to-peer lenders, Lending Club and Prosper, which have both been around for five years or more. These two companies have loaned over a billion dollars since inception through 112,000 loans. Essentially, these companies created a platform that brings lenders and borrowers together. The beauty is Lending Club and Prosper do a credit analysis on the borrowers using FICO scores and other proprietary methods. Borrowers deemed a solid credit risk can usually borrow from 5% to 8% while the riskiest borrowers get high double digit rates. These two companies review thousands of borrowers and turn down those they estimate are unlikely to repay. As a lender, you can review the borrower’s profile and decide to invest (or not) with that borrower. You can invest as little as $25 for each borrower. With $1,000, you can diversify into 40 loans. For those who would rather not go through numerous borrower applications, Prosper and Lending Club have a tool that lets you set initial criteria such as desired credit risk or interest rates then they invest the money for you.

Lending money to people you don’t know or taking money with an FDIC backing to an alternative without this guarantee may scare you – and rightfully so. However, the companies have years of data to give investors a solid understanding of the default rates. At both organizations, the most creditworthy borrowers default less than 2% of the time while the riskiest borrowers default about 13% of the time.

Let’s assume you invest $1,000 into 40 loans at $25 per loan evenly across the highest to medium creditworthiness. If the numbers provided by the companies is true, you could expect a 5% default, meaning you only receive $950 of your initial principal back upon maturity. However, over the course of the loan (the options are usually 12 or 60 months), you would earn approximately $78 per year on that $950, which is an 8.2% return. That sure beats the 1% you receive from the bank.

One downside is the liquidity of the loans. You can sell them, but you have to use the Folio Trading platform. No guarantee is made that you will find a buyer or that you will get the full value of the loan. Also, the companies are not registered yet in every state. You need to determine if your state is registered. Even with no FDIC, a default risk, and lack of liquidity, peer-to-peer lending is an excellent alternative to money markets and CDs.

For full disclosure, I have a Prosper ad on this site so I can receive compensation from Prosper if you click on my link and sign up. If you think peer-to-peer lending is right for you, I would love for you to click on that link. My kids are getting close to needing braces. LOL

Kirk Kinder, CFP® is the Founder of Picket Fence Financial, a fee-only financial planning and investment management company dedicated to saving folks from Wall Street. Picket Fence Financial does  this through a few different ways. One, our fee-only approach ensures our advice is tailored to our clients needs and not driven by commissions.  Two, we minimize costs for clients by utilizing low cost Exchange Traded Funds (ETF) and aligning our internal operations to keep our company costs down (and passing this along to our clients). Third, we offer a la carte planning, which means our clients decide how they want to work with us. Rather than forcing clients into our model of planning, we offer hourly, retainer, or asset management options (or a combination thereof).

All information on this site are the opinions of Kirk Kinder, CFP® and should not be construed as investment, tax, estate or insurance advice. Please consult your own specialist for personal assistance.

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