Screen Shot 2013-10-22 at 12.37.10 PM.png

Photo by Crystal under a Creative Commons license from Flickr

Social lending, also known as peer-to-peer (P2P) lending, has been in practice for countless generations, but it has recently taken on renewed significance in the sharing economy.

In a nutshell, social lending in its modern incarnation is a lending system where people who need funding can bypass banks and connect instead with peers (usually strangers) willing to grant them a loan. It’s primarily conducted over the Internet via one of the growing number of lending companies, such as Lending Club. The company acts as a broker between parties, supplying services and infrastructure designed to make the process of lending and borrowing as smooth, safe, and mutually beneficial as possible.

Today, social lending makes sense for investors looking to park money where it can net steady returns, and is also popular among people looking to supplement a fixed income or ramp up their retirement savings. The funds social lending makes available are especially beneficial for anyone struggling to secure a loan from a traditional lender, whether he or she needs resources to start a small business or to pay down high-interest debt. An additional draw for investors is the chance to make a sound investment that outperforms the interest rate of a typical savings account, while at the same time providing much-needed cash to credit-worthy individuals who have been under-served by the system.

If you recognize the power of social lending and are ready to give it a try, consider these five best practices for success:

Know the risks

Whenever you make a loan, there's always an inherent risk. Defaults are an unfortunate reality of P2P lending that the overwhelming majority will encounter sooner or later. Beyond wholesale losses due to defaults, other prominent risks to consider include complications related to the financial health of the lending company you are working with, as well as regulatory or legal developments that could impact your investment prospects going forward.

Online social lending is still a relatively new industry, and regulations can vary greatly between states and change year to year. It's hard to say whether or not the trend will continue to thrive. Above all else, when you take on an investment that is not guaranteed, it's important to commit only what you can afford to lose.

Work with a reputable company

No matter which lending companies you’re considering, it's important to carefully vet each one before risking your hard-earned money. Take everything into consideration from how long the company has been in business to the system of grading and credentialing they use when determining quality borrowers. You should look for companies that practice transparency, provide facts and statistics about their lending history, and portray realistic default rates and investor performance. Start with Google search when you begin your investigation, then call the company if you have additional questions.

Diversify your investments 

As with investment portfolios, diversification is key to a safe and productive P2P lending strategy. The online social lending structure makes it possible in most cases to diversify your loans in as low as $25 increments, so you share the risks of default with many investors on a single loan. Many experts and lending companies recommend starting an account with a minimum of $2,500 in order to achieve enough diversification to effectively guard against default rates of 2% to 3%, the industry norm.

Know your borrowers

A diversified P2P lending portfolio can include hundreds of notes, which makes it virtually impossible to review each individual borrower, but it's important to create filters for evaluating your potential loans. For quality control, you can set account filters that show you only specific types of loans and borrower grades. By analyzing results based on the type of borrowers you work with, you can tailor your filters over time to achieve above-average returns.

For lenders who commit larger amounts to single notes or take on higher risks to ramp up their income potential, lending companies will provide details on the individual borrowers and proposed use of funding. This allows the lender to cherry-pick borrowers.

Have a plan

People tend to charge into online social lending without making a plan, simply because it’s so easy to initiate. Don’t forget to set investment goals and assess risk thresholds based on your financial position and realistic needs. In just a few short months, distributions will start hitting your account—and you need to be ready with a reinvestment plan. Only then will your money continue to work for you.

Social lending provides an exciting new opportunity for investors to see greater returns while providing loans to borrowers at rates that trump those offered by traditional banks or business credit cards. By understanding the dynamics, identifying the most promising partners, and developing a thoughtful ongoing investment plan, you can tap into a relatively safe and dependable stream of personal income.




David Bakke is the author of the personal finance book, Don't Be a Mule. He lives in Atlanta and frequently writes about topics related to money management, small business, and investing.