A savings account alternative: peer-to-peer lending

You've socked away a healthy rainy day fund in your high interest online savings account. What's next? Is there an alternative to the stock market, in which you can choose your risk level, increase your potential earnings and diversify your portfolio?

Lending Club, founded in 2006 and based in California, offers such an alternative with peer-to-peer lending.

How peer-to-peer lending works:

Borrowers are vetted

As an example of peer-to-peer lending, Lending Club categorizes prospective borrowers based on credit histories and other financial information. To be accepted, a borrower must have a credit score of at least 660 minimum, a debt-to-income ratio (excluding mortgage debt) of less than 25 percent, and no recent delinquencies, bankruptcies or liens. According to Renaud Laplanche, co-founder of Lending Club, about 90 percent of borrowers are rejected.

Interest rates are assigned

For the 10 percent that remain, Lending Club assigns an interest rate of 5.5 percent to 21 percent or more depending on a borrower's credit rating. The higher the perceived risk, the higher the interest rate. Loans can be anywhere from $25 to $25,000. Loans are 3-year or 5-year notes and come with an origination fee of 2 percent to 5 percent.

Investors choose borrowers

Investors decide which borrowers to lend to. To help them make this decision, Lending Club provides a wealth of information about the borrowers, such as the purpose of the loan, income, current employer, length of employment, home ownership, credit score, delinquent account information, credit lines, public records and more. Investors also can build a personal portfolio of borrowers and ask the borrower questions for clarification.

Lending Club by the numbers

According to Laplanche, Lending Club expected to make $120 million in loans in 2010, up from $52 million in 2009. The Lending Club website reported more than $195 million in loans processed through the end of 2010 and more than $15 million in interest paid to investors.

These earnings are not without risk. Loans made through Lending Club are unsecured, meaning if the borrower fails to make a payment for four months, the loan is charged off and the investor loses. Lending Club reports a default rate of less than 3 percent.

Astute investors who are selective about the borrowers they lend to are more likely to come closer to Lending Club's average annual return of 9.68 percent.

Is peer-to-peer lending right for you?

First of all make sure your own financial house is in order and that you have adequate savings for emergencies. As with any investment that offers high returns, there's always risk. Do your homework to decide if peer-to-peer lending makes sense for you.

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