The following is a compilation of an interview with a YMF reader, Ernest. He’s been on the site before, recommending Mint.com. He’s certainly up on his finances and is always a pleasure to speak with. Thanks Ernest for your help with this article!

There always seems to be some fancy new way online to invest your money. It’s tough to judge whether this new thing is legit, or just a scam. I’d like to introduce you to one such company, Lending Club. You may have heard of them before, they are an online site that connects borrowers with lenders, or people with money to lend with people that need to borrow money. This article will review the investing side of things, but from a borrower’s perspective, it’s equally as good of a deal.

What is Lending Club?

As stated earlier, the basic idea behind Lending Club is to connect lenders with borrowers. Before Lending Club, banks and credit cards were basically the only way to borrow money. Getting a loan from a bank for something other than a car or house is pretty difficult. Getting a loan from a credit card, in the form of making purchases and not paying for them immediately is easy, but you can be hit with interest rates of up to 30%.

Who uses Lending Club?

Only about 20% of people that apply are approved for a loan. According to the statistics on their site, the average borrower makes $73K annually, has a 700 FICO score and their debt-to-income ratio (an important measure to see how monthly debt payments compare to your monthly income) is 17%. These are quality borrowers that are deemed trustworthy. The problem that leads these people to borrow is the fact that the average credit card carries an interest rate of 17%. Paying down debt at a 17% interest rate is tough. Student loans are another big source of debt for yopros, and if you got stuck with a private loan, your interest rate on those could be double digits. Finding a lower interest rate could really make things easier.

Then there are people like many of you that have some extra money floating around. Finding solid investments aren’t easy, as savings accounts pay pennies and the stock market can be risky. What Lending Club does is it takes some of our extra money and lends it out to the people in the above scenarios. It charges an interest rate from 7.5% up to 25%, depending on the borrower’s credit worthiness. Lending Club then takes a small cut, and passes the rest of that interest along to us as investors. Over the past couple of years (Lending Club isn’t that old), the median investor has seen an annual return of 8.6%. That’s a solid return for an investment in today’s day and age. Ernest has experienced an annual return (over 3 years) of about 11%, and another friend I know has seen a return of 13% so far this year.

How does it work for an investor?

Firstly, this isn’t a liquid investment, meaning that it is not one that you can jump in and out of with ease, as you can with stocks. These loans, or ‘notes’ are good for 36 or 60 months, aka 3 or 5 years. These are similar to a car loan, and will take some time to pay back. Therefore, any money (unless the borrower pays the loan off early) will be tied up for 3 to 5 years. Loans are divided into notes, which are in increments of $25. Most borrowers will borrow a couple thousand dollars, and so their total loan will be divided up into 100-200 individual sections. This is a way for you to limit your risk of someone defaulting on a loan, as you spread your total investment into many $25 pieces that are divided amongst many loans. Your borrower will make a monthly payment, of which you’ll get like $0.70. Over time, you’ll get back your $25 + whatever interest they’ve paid, based on their credit worthiness. After the loan is paid back, you can either withdrawal that money, or re-invest it.

As an investor, you can certainly do the loan picking yourself, like “I want to invest in this person from Virginia that is borrowing money to pay off credit cards.” The easier and less time consuming route is to let Lending Club pick the loans for you. You set your investment criteria (i.e. only solid less risky loans, a good blend of risk types, only 36 month loans or only or only 60 month loans), and Lending Club picks them for you. You can also put your account on auto-pilot by selecting the option to re-invest all your money.

What happens when the borrower doesn’t pay?

There is always the risk of default on Lending Club loans, but that’s true for any loan. Default rates are a little under 10% for loans, and both Ernest and my friend reported seeing this same statistic in their own investing. The good news is that people rarely will default on the first payment, and will have been making payments for a while. Sometimes you get your principal ($25) back but not much interest. Losing all $25 is pretty rare, but that’s the nature of the beast. You’ll have a lot of loans that pay, and a few that default.

Lending Club loans are ‘unsecured’, which means the loan isn’t backed by any collateral. With a car or home loan, the bank is coming to take the house or car when you default. Therefore, technically the borrower could choose not to pay the loan. Lending Club does follow industry best practices, and will pursue the borrower for the payment, as best they can. Defaulting though will affect the borrower’s credit, and if you’re trying to pay down credit card debt, you’re hopefully not trying to eliminate a really good alternative (Lending Club) to high interest credit cards.

In summary, Lending Club is a really interesting solution to a very real problem. It takes people with money to lend and pays them a nice return that would otherwise be difficult to obtain. It lends money to people that need it, and offers them a competitive rate, one much better than they could get from traditional sources. If you do decide to invest in Lending Club and seek a nice return, don’t forget that your money will be tied up for 3-5 years. Also, it’s certainly not a risk-free or even low-risk investment, so like any other risky investment, don’t allocate too much of your overall portfolio to it. I plan to start investing in Lending Club myself very soon, so feel free to reach out with more personalized questions and stay tuned for a later blog post in which I report my experiences!