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Hunting for Yield? One Place You May Not Have Looked

Andrea Bricco | Brand X Pictures | Getty Images

The quest for yield is sending investors into some unusual places, with some even turning to lending out their own funds to those who can't —or don't want to—borrow from traditional banks.

Private lending has become an increasingly popular tool that wealth managers are steering their clients toward.

Often referred to as peer-to-peer lending, investors can participate in several ways. They can use private equity firms, wealth management advisers or web sites, all of which can aide in screening prospective borrowers who take out loans for anywhere from a few days to years. And there's no limit to how little or how much you can lend.

The industry is regulated by the Securities Exchange Commission, which enhanced its oversight in 2008, as well as the Consumer Financial Protection Bureau.

With yields extremely low on all fixed-income instruments outside of junk bonds, peer-to-peer lending offers return that many bonds simply don't provide. (Read More: How the Fed Is Pushing Investors to Buy Junk Bonds

"For some investors this is a great alternative," said Kimberly Foss, founder of Empyrion Wealth Management in Roseville, Calif. "It's not something that's a money market alternative, but it's a great way to get a great yield without too much more additional risk."

Foss would know - in addition to directing her clients toward private lending she has committed her own money.

Since entering the space she said her annualized return has been 7.7 percent on loans made to a variety of borrowers with varying levels of credit quality.

Lenders can get 15 percent interest or more for lower-quality borrowers, an onerous rate to be sure but less than predatory fly-by-night payday lenders and many other nonbanking institutions, and even less than some credit cards.

Consumer credit has been on an upswing over the past three years and currently stands at $2.75 trillion, according to the Federal Reserve. That's a gain of 13 percent since the 2009 bottom. Credit increased at an annualized pace of 6.2 percent in October, the most recent month for which data is available.

Nonfinancial credit has remained steady at about $52 billion during that time, with much of the actual growth in total credit coming from student loans. (Read More: Student Loan Debt Hits Another New Record: Study)

But with the Fed likely to keep interest rates near zero for at least two more years, private lending is showing signs that it could be a real growth area in credit.

Web sites have emerged that help facilitate the process. The companies running the sites - Prosper.com and the larger Lendingclub.com are the two most prominent - perform due diligence on both borrowers and lenders, with their fee being a percentage of the total loan.

They even help with delinquent loans by appointing collection agencies.

Lendingclub.com says it has helped fund about 95,000 loans worth $1.16 billion. Prosper.com says it has 1.6 million members and has helped fund $440 million in loans.

Credit scores for borrowers are generally 640 and up, while lenders usually have to make at least $70,000 a year to participate, Foss said.

But interest can get stratospheric as well.

Prosper.com says borrowing rates can run as high as 35.8 percent, while the average return for lenders is about 9.7 percent.

Lendingclub.com advertises three categories of rates - 5.66 percent, 8.89 percent and 10.27 percent.

"There is a risk of default. Nothing is guaranteed," Foss said. "But there's a degree of due diligence by both of these companies."

Higher net-worth investors worried over the state of the bond market - which some fear is approaching bubble stage - are natural players in the private peer-to-peer lending world.

"Our financial advisers want to have a complete relationship with their clients," Greg Fleming, president of Morgan Stanley Wealth Management, said during a recent CNBC appearance. "So they do a terrific job on the assets-side of the client's balance sheet. They also want to help their clients when they have borrowing and lending needs."

The rush to yield, though, presents both returns and traps that traditional buy-and-hold stock investing and investment-grade bond buying does not. (Read More: What Investors Should Do If We Go Over the 'Cliff')

That has some investment professionals throwing up caution signs about peer-to-peer lending.

"Like anything else you have to do your homework. That's the important thing," said Carol Roth, head of Intercap Merchant Partners in Chicago. "I'm not in favor of the cool investment du jour. That's always risky."

Roth understands the pursuit of yield in an environment where returns are so low, but encourages caution.

"We can get ourselves into trouble. It's really important to do due diligence and in a balanced way. I certainly wouldn't put all my eggs into that basket," she said. "All it takes is a couple of those things to go bad, and we all know how that movie ends."

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