In December 2015, the Federal Reserve raised the federal funds rate by a quarter of a percentage point. That was the first time the Fed had raised rates in nearly a decade. While federal funds rate changes donât directly impact peer-to-peer (P2P) loan interest rates, lending platforms may begin increasing their rates. If youâre investing in peer-to-peer loans, itâs important to understand how that may impact your portfolio.
Rising Rates May Mean Better Returns
Personal loan investors make money by claiming a share of the interest thatâs paid on the loans, in proportion to the amount thatâs invested. If the platform youâre using raises rates for their borrowers, that means youâll likely see higher returns.
Thatâs especially true if youâre open to funding high-risk loans. Peer-to-peer platforms assign each of their borrowers a credit risk rating, based on their credit scores and credit history. The loans that get the lowest ratings are assigned the highest rates. For example, Lending Clubâs âGâ grade loans (the loans that go to the riskiest borrowers) have interest rates of 25.72%.
Assuming borrowers donât default on their payments, these investments can be more lucrative than lower-risk loans. Using Lending Club as an example again, F and G grade loans historically have had annual returns of 9.05%, which is nearly double the 5.22% return that investors earn from low-risk âAâ grade loans.
The Downsides of a Rate Increase
While rising interest rates may put more money in investorsâ pockets, there are some drawbacks to keep in mind. For one thing, itâs possible that as rates rise, borrowers could decide to explore other lending options. If that happens, there would be a smaller pool of loans for investors to choose from.
To compensate, peer-to-peer lenders may resort to issuing lower-quality loans as rates rise, but that could be problematic for investors who prefer to steer away from riskier borrowers. If the platform you use no longer offers the kinds of loan products you want to invest in, youâll have to reallocate those assets elsewhere to keep your portfolio from becoming unbalanced.
Finally, rising interest rates could result in a higher default rate. Increased rates mean that borrowers have to pay a lot of money for taking out personal loans. If the personal loan payments become unmanageable, a borrower may end up defaulting on their loan altogether. Some platforms refund the fees that investors have paid, but they usually donât refund their initial investments after borrowers default.
What Investors Ought to Consider
If youâre an active P2P investor or youâre thinking of adding P2P loans to your portfolio, you canât afford to overlook the risk thatâs involved. Financing the riskiest loans is a gamble, so itâs important to consider the consequences of putting money into those kinds of investments.
A good way to hedge your bets is to spread out your investments over a variety of loan grades. That way, if a high-risk borrower defaults you still have other loans to fall back on.
If you want more help with this decision and others relating to your financial health, you might want to consider hiring a financial advisor. Finding the right financial advisor that fits your needs doesnât have to be hard. SmartAssetâs free tool matches you with top financial advisors in your area in 5 minutes. If youâre ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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