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More investors turn to P2P lenders for high yield

The volatility in the stock markets and rock-bottom rates in most categories of bonds have prompted more investors to turn to peer-to-peer lending platforms for higher yields.

It's easy to see the appeal. Since 2009, average net annual returns for investors who lent money through Lending Club and Prosper Marketplace, two of the largest peer-to-peer lending platforms for consumers in the U.S., have ranged from 5 percent for its most creditworthy borrowers to to 9 percent for its subprime borrowers. (The average credit score for a borrower in Prosper's lowest-rated loan category is 664.) Compare that to about a 1.5 percent yield for a five-year Treasury bond, as of Friday, and about a 2 percent yield on average for Aaa-rated, 5-year corporate bonds.

"Demand from borrowers and investors, retail and institutional, remains at an all-time high," said Ron Suber, president of Prosper Marketplace, adding that the company is on track for a record quarter. "On a relative basis to the fixed-income market, Prosper's loan performance is even stronger given the recent market volatility."

Lending Club, which had an initial public offering in December, has seen loan originations nearly double year over year to $1.9 billion as of June 30 and more investors using the platform. (See chart below.) A Lending Club spokeswoman said that "it's early days, but if the volatility continues, we certainly wouldn't be surprised" if that increased demand from investors for peer-to-peer loans.

Source: Lending Club

Either way, peer-to-peer lending is projected to grow in popularity. A $5.5 billion industry in 2014, it's expected to grow to $150 billion by 2025, according to accounting firm PwC.

Here's how peer-to-peer lending works: Borrowers receive money directly from investors, both individual and institutional, while online marketplaces, such as Lending Club and Prosper, take a fee from issuing the loan. Both Lending Club and Prosper charge investors a 1 percent annual fee. Lenders typical issue three- and five-year loans to consumers with no prepayment penalties for borrowers.

As with any asset class, there are risks. Borrowers can default, peer-to-peer lenders could go bankrupt and regulations for these loans may change.

"Peer-to-peer lending should be viewed as a higher-risk component to an overall portfolio," said Don Wilde, a certified financial planner in Gilbert, Arizona, who has clients who have invested in peer-to-peer loans.

Whether you can invest on a peer-to-peer lending platform depends on the state where you live and whether you meet your state's "financial suitability" conditions. Investors can use Lending Club in 33 states and Prosper is open to investors in 32 states, but the states don't overlap. For example, you can use Lending Club in Texas, but you can't use Prosper there.

Federal regulation might be coming to peer-to-peer lenders soon. In July, U.S. Treasury Department began studying peer-to-peer lenders.

Another factor to consider: Peer-to-peer loans are untested by rising interest rates or a recession. While Lending Club and Prosper launched before the financial crisis, most of their loans were issued during the recovery. Both companies say that their technology enables them to operate more efficiently than the traditional banking system and that cost advantage will transcend any rate environment or economic cycle.

"Peer-to-peer lending is a small and unproven asset class," said Peter Renton, publisher of Lend Academy, a website that covers peer-to-peer lending. "But my investments keep plugging along and the asset class looks more attractive than it did 10 days ago."

How can investors get started? Renton recommends that investors diversify their peer-to-peer loan holdings, investing in a portfolio of at least 200 loans. The minimum to invest in a fraction of a loan on Prosper and Lending Club is $25, so a 200-loan portfolio would cost at least $5,000. Both companies allow investors to open IRAs.

Cash can build up quickly in peer-to-peer investing accounts. Renton recommends investors regularly check their accounts and reinvest the cash since it earns nothing on the sidelines.

Lending Club and Prosper provide tools to evaluate the creditworthiness of their borrowers. But exactly how the companies rate their borrowers is proprietary, so it is unclear how an economic downturn or rising interest rates would affect borrower ratings or the companies' risk management.

Renton, for one, isn't concerned about the peer-to-peer lenders' future prospects. "If they screw up, investors won't use them," he said. So they have plenty of incentive to ensure that borrowers can repay loans and returns remain high.