Peer To Peer Lending Review – Dangers Revealed

There’s More To P2P Lending Than Is Commonly Understood…

Key Ideas

  1. Uncover the hidden dangers behind P2P lending.
  2. Learn which potholes you must avoid to enjoy peer to peer lending profits.
  3. Reveals how P2P marketing tactics exploit both borrowers and lenders.

In a world of zero percent interest rates, peer to peer lending can look mighty tempting for yield hungry investors.

Don’t be deceived. Your investment profit is determined by mathematical expectancy (Expectancy=(Gain on a Winning Bet * Probability of Win) + (Loss on a Losing Bet * Probability of Loss), or more commonly understood as “probability times payoff”).

When filtered through that lens, the problems with peer to peer lending are immediately obvious:

  • Your gain is strictly limited to the interest rate; whereas your loss can be 100% creating a negative risk/reward ratio.
  • Your probability of gain or loss is impossible to define, because the system is too new to have been adequately stress tested.

Simply put, if you’re playing the peer to peer lending game from the investor side, then you’re gambling – not investing – because you’re working with an unknowable, and potentially unfavorable, mathematical expectancy.

I wish I had written the following peer to peer lending review myself, but Doug Nordman of beat me to the punch with a well researched three-part analysis of peer-to-peer lending.

Rather than re-create the wheel, I asked him to boil his series down to a useful “consumer’s guide,” explaining the various issues you must consider as a smart investor when looking at peer to peer loans.

Take it away Doug…

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What is Peer To Peer Lending?

Peer-to-peer lending brings crowd-sourcing to unsecured loans between individual lenders and borrowers. P2P company websites greatly reduce the transaction costs of getting a loan, allowing borrowers to enjoy lower interest rates.

Lenders can diversify their own risks and achieve higher interest rates than currently available on CDs or money markets.

On the surface it sounds good, but before you leap into P2P lending, you need to be aware of issues with the companies, their marketing strategies, and the lender’s poorly-understood risks.

Yes, it’s true that many borrowers have paid off their debts with P2P loans, and some individual lenders have built up six-figure portfolios earning double-digit returns.

However, in the last year, too much money has started chasing too few loans through companies that are struggling to grow their business.

Peer-To-Peer Borrowers

Let’s start with the dangers faced by borrowers.

A P2P lending company seeks borrowers with credit scores as low as 600, but usually at least 660. Borrowers apply for unsecured loans of $1,000-$35,000 for 3-5 years at APRs as low as 7%. (Borrowers with lower scores, or with high debt-to-income ratios, will pay APRs as high as 35%.)

The P2P company websites verify ID and run a credit check, but don’t always verify a borrower’s income or other debts. Their risk committees use proprietary software to assess a loan’s default risk and set its interest rate. Borrower’s anonymous loan applications are posted on the company’s website for lenders to bid on.

When lenders have agreed to fund the loan, the P2P company has the borrower sign a promissory note in exchange for the funds. (The P2P company takes an origination fee of 1%-5%.)

The P2P company holds the promissory note and services the borrower’s loan payments, distributing them to the lenders (for another 1% fee – are you noticing a pattern of the high fees involved?).

The company assesses penalty fees for late payments. If the borrower stops paying, then the company adds on more fees and eventually declares the loan in default.

Since the loans are recourse debts with no collateral, the P2P company can report the default to a credit-reporting agency, sell the note to a collection agency, and obtain a court judgment against the borrower.

Most borrowers want to consolidate their credit-card debt at a lower interest rate. Others with poor credit want to start a business, renovate their homes, or even pay for a wedding or a vacation. (More details are discussed at

The P2P companies use the same marketing tactics as the credit-card industry and payday loan businesses to encourage borrowers to keep taking loans!

The P2P websites are very easy and fast, and the approval process is much quicker than traditional loans. The companies offer enticing stories of customers paying off their debts (at lower interest rates) and living the lives they deserve, thanks to the crowds of eager lenders who are happy to help them achieve their dreams.

P2P companies encourage borrowers to indulge in thoughtless spending.

Even if borrowers consolidate credit-card debt and lower their interest rates, it still doesn’t help them change the habits that got them into debt in the first place. Debt is a personal problem of spending more than you earn, and a P2P loan won’t help you change your overspending habits.

In short, P2P programs are a band-aide that treats the symptom of a debt problem rather than the underlying cause of the debt problem.

Peer-To-Peer Lenders

Lenders use a P2P company’s website to screen loan applications and build a diversified portfolio of loans at higher interest rates than can be earned elsewhere. The carrot is convenience and interest rate.

Lenders can diversify between high-quality loans with low interest rates, or riskier loans with much higher interest rates. The low-interest loans are predicted to have low default rates, and the risky loans are expected to have much higher default rates.

Investors can analyze the P2P company’s extensive database of loans and payment histories, but they can’t review the risk committee’s decisions on interest rates, or analyze their proprietary software.

Investors are encouraged to diversify by investing small amounts in hundreds or thousands of loans.

Lenders can use the P2P company’s selection software or build their own filters. A number of blogs and third-party vendors supply even more analysis tools to let lenders sort through databases of tens of thousands of applications.

The P2P companies are expediting this process with automated features to “help” lenders choose loans and invest more quickly (for a small additional fee… again). Some of these services cater to their institutional customers, and others are rolled out to their individual lenders.

Most individuals invest $5,000-$25,000 @ $25-$100 per loan. (Financial companies and institutional investors build much larger portfolios for their own clients.)

Once a lender takes a portion of a loan, their money is deducted from their holding account, and they’re assigned their share of the (anticipated) payments for the next 3-5 years.

The P2P company holds the borrower’s promissory note and distributes monthly interest/principal payments, deducting a 1% servicing fee.

Lenders are also entitled to late fees, but if a loan goes into default, then the P2P company may keep additional fees and penalties to offset their collection expenses.

The few loans that lapse beyond 30 days are only brought current by borrowers about half the time, and the other half are eventually declared in default.

Default rates range from 2%-4% on the “best” loans, but default rates for high-risk loans can exceed 10%. Investors accept the risks of unsecured lending just like credit-card companies, only at lower interest rates than card companies.

Lenders have to analyze thousands of loans to avoid those likely to default — or else trust the company’s automated tools. A well-chosen portfolio of risky high-interest loans can earn returns above 15% after defaults.

P2P loans have terms of 3-5 years, which means actual returns are unknown until the full portfolio of loans has matured and paid off (or defaulted). Until that date, your assets face liquidity constraints. There is a small secondary market on FOLIOfn, but most are sold at a discount.

Sellers may need several weeks to sell their loans at par (minus the 1% transaction fee). During a recession, there may be no market at all for these loans, and the loans still have a default risk.

The Lure of High Returns

Unfortunately, many lenders are distracted by the high returns, and fail to properly assess the risk.

When you loan money through a P2P company, you can’t tell whether you’re getting paid enough for the risks that you’re unwittingly taking. The interest rates are set by the companies using proprietary software that estimates default rates from history.

Unfortunately, the major American P2P companies, Lending Club and Prosper, have been in business for less than a decade. There’s no indication that their default estimates will be accurate during an economic downturn.

During 2007-08 some of their default rates soared (in one month by over 30%). Even worse, both companies spent much of the Great Recession on the sidelines pending regulatory approval of their business model, so their latest algorithms have never been tested during a real economic decline. Their current portfolio history is barely longer than their five-year loans.

(Editor’s Note: If you are thinking of lending money peer to peer, then read that last paragraph again. It is absolutely key. The risk of loss has not been adequately defined but anecdotal evidence is unfavorable. This undefined risk of loss will determine the mathematical expectancy of your investment.)

An investment portfolio has to balance risk and reward. Mathematical models can’t faithfully reproduce reality, especially during extreme bull & bear markets, so results will vary from predictions.

Nobody complains when returns are higher than expected, but everyone is unhappy when returns are lower. Asset allocation and diversification can limit the damage of a black swan event, but the math can’t predict when it will happen.

Even worse, a P2P lender’s return is limited to the interest rate. Even if every loan is paid on time, lenders can only receive the rate set by the interest committee (after fees). Lenders can’t tell whether they were adequately compensated for their risk, or whether they just got lucky.

Nobody knows what will happen to loan default rates during a recession or a credit freeze, but those incidents were highly destructive in 2008-09. P2P lenders could have years of good returns before disaster strikes.

It’s like driving without seat belts: nothing bad happens for years, and you conclude that the risk is small. However, when a crash inevitably happens, the result is devastating, and there’s no collateral or insurance for your capital at risk.

Stocks may recover and even defaulted junk bonds may eventually repay 30% of principal, but defaulted P2P loans almost never pay off. The P2P lending companies will keep any funds recovered by the collection agencies or the courts.

Even if lenders build a diverse & conservative portfolio, it’s still difficult to distinguish luck from skill. Financial planner Jason Hull demonstrates that a statistically rigorous loan portfolio can require over $180,000 (over 7200 loans @ $25) to be confident that returns will match expectations.

The P2P companies advertise that “breaking even” requires a portfolio of at least 800 loans (at least $20,000). Few lenders will take the time & effort to screen tens of thousands of loans for those portfolios, let alone have the capital to invest in becoming skillful rather than lucky.

Peer-To-Peer Companies

Unfortunately, Lending Club and Prosper aren’t making money for their own investors, let alone spending more on better mathematical models. Instead of getting rich from their own loans, they’d rather get rich collecting fees from servicing the loans.

Both companies are successful startups (by Silicon Valley standards), but neither is profitable. Lending Club has had at least one quarter of positive cash flow, but Prosper recently narrowly averted a brush with bankruptcy.

(Prosper raised $20 million at a huge discount to their share value, and then replaced the board of directors as well as most of their executives.)

Their financial survival rests on making as many loans as possible with as little expense as possible, and both companies are struggling to scale for growth.

The pressure to cut expenses and move faster could also tempt them to overestimate returns and cut corners. Both companies inflate their lender’s returns by assuming that funds are reinvested instead of distributed. Claims are based on estimated loan durations and projected default rates.

Both Lending Club and Prosper delay declaring a loan in default for months after the borrower has stopped paying it. Corporate and institutional investors are starting to pour millions of dollars into P2P loans, putting further pressure on the approval process.

An application is essentially just a FICO score and a credit check with verification lagging far behind. (Lending Club attempts to verify a borrower’s stated income on about 60% of their loans, but this takes several days.) Loans are purchased less than 48 hours after they’re posted, and retail P2P lenders are getting crowded out as too many dollars are chasing too few loans.

Will these companies survive? After 7-8 years it looks like the answer is “probably.” More importantly, if either one goes bankrupt, then their loans are protected.

Borrowers will still be required to pay, and backup companies are under contract to take over the loan processing. Lenders should still get paid as long as the turnover goes smoothly.

However, this is a new business model that’s never been tested by a large-scale bankruptcy, and there’s no guarantee that borrowers will continue to pay back their unsecured loans to a bankrupt processor. There could be days or even weeks of confusion and uncertainty before loan servicing returns to normal.

If you’re a P2P lender, then you have to factor the risk of “frozen accounts” into your plan and decide whether you’re being adequately compensated.

Your Weaknesses As A Lender

Lending Club and Prosper both use sophisticated marketing tactics to distract customers from the unpleasant realities. As soon as you land on their websites, you’re tacitly lulled into a number of investor behavioral-psychology vulnerabilities.

Borrowers are already familiar with the myth of “You deserve to live your dreams with our loans!” put out by so many credit-card companies.

Peer To Peer Lending Is Gambling, Not Investing

Research shows how investors use heuristics and biases to make their decisions. We claim to be logical and rational, but our mental shortcuts and emotions interfere with our decisions. The P2P companies are keenly aware of these tendencies — and they exploit them.

Their most blatant tactic is the illusion of control. You’re fooled into thinking that your hard work pays off. You’re using a sophisticated website (or third-party tools) to filter thousands of applications and dig into all sorts of obscure criteria.

Meanwhile, you have no idea whether the data is valid (or even truthful), and you’ll never know whether your return justifies the risks. Most lenders don’t invest enough funds to distinguish luck from skill, but they’ll credit their skill for their success.

The P2P companies also stress their affiliate marketing. Both borrowers and lenders feel like members of exclusive clubs, with teams of people helping each other.

Lenders can get credits for investing or for referring their friends. Lenders are warned that they have to qualify to understand the rules and the risks, yet the company disclosures & disclaimers make the entire process look like an exciting and attractive way to earn high returns.

The social proof encourages you to join the crowd to get in on a great deal. The artificial scarcity and a sense of urgency only make you feel obligated to move faster, before all of the good loans are taken by smarter lenders.

The companies will even automate the process (for a small additional fee), and all we have to do is keep adding money. You’re part of a select group of smart people helping other people. You can afford to join the club, and there’s no need to keep working so hard when you can just sit back and enjoy the streams of passive income.

Worst of all, however, is the lender’s temptation to chase yield. They’re encouraged to pull their money out of CDs, money markets, and bonds to invest them for greater returns.

Should You Be A Peer-To-Peer Borrower Or Lender?

P2P loans don’t solve the root problem that got borrowers into debt in the first place: spending more than they earn. Even worse, borrowers have to pay an additional 1%-5% fee.

While a P2P loan gives borrowers a lower interest rate, they can still do better on their own. Borrowers can pay their debts even more quickly by making lifestyle changes to cut expenses and accelerate payments. Rather than paying fees to a P2P company to borrow, they could use that money to get out of debt.

Lenders are also seduced into a sense of false security. Before you give in to their marketing tactics and start chasing yield, please understand that nobody knows the real risk of the loan defaults.

You have no idea whether the future will resemble their brief historical records (especially during a recession), and you have no idea whether you’re earning enough yield to compensate for that unknown risk.

The P2P companies are already overstating the returns and understating the risks, while you’re simply putting money into an unsecured loan for 3-5 years with limited liquidity.

This is not investing. At best, this is speculating, and at worst, it’s legalized gambling. If you must engage in P2P lending, do it only with funds that you can afford to lose– and regard it as an entertainment expense rather than an investment.

Author Credit: Thanks to Doug Nordman for sharing his well researched insights in this peer to peer lending review. Doug is a retired U.S. Navy submariner and the author of “The Military Guide To Financial Independence & Retirement.” The book shows service-members, veterans, and families how to achieve their goals on their terms, and more than 50 others shared their stories to explain the simple techniques. All revenues from his writing are donated to military charities.

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Justin Caton
Justin Caton

I just signed up for an account at Lending Club last night so you have good timing!


Of course it's gambling...all unsecured loans those who held/hold mortgages found out when housing prices went belly up, and home resale only partially secured the debt. But, the good news, is called 'pooling'. If you have enough statistical events, pooling results in an 'acceptable' level of risk with many lenders.

So, if you are worried about gambling, as you should be...think p2p as gambling in a house that offers much better odds than the casinoes, and good chance that you will win something....better than the banks...

I must disclose that I have been carefully using p2p as a balance in my portfolio for 7+ years! and the results have been exactly as expected. My big risk is putting more $$ in.

Kevin Watts @Graduatingfromdebt
Kevin Watts @Graduatingfromdebt

Thank you for this fantastic post. I actually was looking to starting investing in Lending Club but after reading this it gives me a better understanding of the risks involved.


I've been investing in P2P loans for 5+ years and I rode the wave up and down with Prosper in the 2007-08 boom and subsequent bust.  My net IRR for that period was -1.5%... when I compare that to my conservative 60/40 allocation in the stock and bond markets, I'm not very concerned about catastrophic losses.  I got back into P2P 2 1/2 years ago and my XIRR is 10.4% (I assume all 30+ day lates are 100% losses).  I think there's risk but I believe savvy investors are compensated for that risk as compared to today's stock and bond markets.

JP Bourget
JP Bourget

I put in a significant amount of time, research and thought (not emotional) into Lending Club over the past 3 years. The data that they give you is so massaged - for example - I've had 26 loans evenually default (out of over 250) and still they say I am making 10%. Simply not true - if you actually track loans in quicken (there are a few techniques out there) you can get the real idea of your returns. They are not stellar. 

I am now waiting for all my loans to mature and withdrawing my money as they do. 

I agree strongly with the author's assessment is there is now too much money chasing not enough good quality loans. This is different then the lending club of 2008-9. It really caught on in I'd say 2011 when institutional investors jumped in as well as when lending club relaxed their verification requirements. 

The only good investment in Lending Club is to be an owner and make money off of servicing. It's a very up front commission model for them. 


I'm also a long term P2P investor, and I agree with Peter on all of his points. I've reviewed both on my site, and with updates for almost four years now with Lending Club.

Are they perfect, NO! Should they be part of your asset allocation? I think for high net worth individuals yes. It is true they aren't for everyone, but for the most part can earn stable returns from them. Unfortunately in the current low FED rate environment individuals might be tempted to enter without fully understanding the risks. 


Thank you Todd for sharing that information with your readers. 

The asymetry of information is so staggeringly in disfavor of the lender that I wonder if ANY interest rate would justify the risks involved. 

Most people seem to think an estimated return on a financial brochure is a guaranteed return. We are hard wired to crave that free lunch, that windfall ... But in nature that free lunch is extremely rare.

As an aside I particularly enjoyed the part where Doug lists some of the deceptive ways those P2P companies use to trick people into lending and borrowing. It's always good to be reminded how easy we get manipulated by corporations of all sorts (not only P2P). That's basically the reason why I don't watch TV and read newspapers, I'm no smart enough to not fall into their traps. 

- Cheers

The Military Guide
The Military Guide

@LendAcademy Peter, it's good to see that LC is profitable.  The 10K I was reading in April & May quoted "positive cashflow".  From recent events, however, I wonder if Prosper might not be on a better footing.  Feel free to review the details in the posts on

As for the rest of the statistics, I think there's still insufficient history to distinguish luck from skill.  I look forward to a statistician who can review Jason's analysis and come up with a better model.  

Let me re-emphasize one more point.  Yes there are valid risks.  But worse yet, you are not being paid enough to compensate you for those risks.  I'm not sure that even credit-card companies or payday loan companies are being paid enough to compensate them for their risks.  That's why P2P lending is speculating, not investing.

It'll be interesting to see where the P2P market is by 2025.  I sincerely hope you and a lot of other investors are millionaires and rock-star P2P coaches.  However I think I've seen this movie before.


Well that was quite the negative review of p2p lending, I wouldn't want to put a dime of money into Lending Club or Prosper if everything in this article were true. Thankfully, that is not the case. Here are some corrections/clarifications:

1. Lending Club is profitable - just read their latest 10-Q.

2. Now, I am not a statistics expert but every expert I have spoken with thinks Jason Hull's claim of needing 7,200 loans to produce a statistically valid return is ludicrous.

3. To compare p2p lending to payday loans is a tremendous disservice to those borrowers using p2p lending to get out of debt. Over 80% of borrowers have successfully paid down debt within six months of taking a loan.

4. It is true that there is less than a decade of history at both companies. But the majority of loans are three year loans and there have been thousands of loans that have matured and been fully paid back. This is more than enough data to do a rigorous statistical analysis,

5. Calling p2p lending gambling is also quite a claim. I have been investing for 47 months and my returns have been positive every month except one. I was down less than 1% on that one month that was three years ago now. I am widely diversified in pretty much every asset class there is and no other investment I own that has as good a track record as my Lending Club and Prosper investments. Maybe I have just been very lucky these past four years....

Look, p2p lending is not for everyone and this author points out some valid risks. But to say it is completely unworthy of anything but play money does your readers a disservice. Thousands of investors have been earning good returns for many years. That is why I continue to invest more money into this asset class.