If you’re not familiar with direct person-to-person (P2P) lending over of the internet now, you likely will be soon.

P2P is poised to make gains in popularity over the next few years. Books and the news media are teaching us about it, new businesses are seeking out niche borrowers who are being turned down for loans elsewhere, and existing P2P companies are seeking to raise our awareness through search engine and other marketing.

The prospect of lending or borrowing directly with another person is also likely to sound more attractive to many in the future. Individuals and businesses are having a hard time accessing personal loans from traditional sources. Rates for borrowing are up.

Meanwhile, savers want higher returns and income than they are getting on bonds, and many are noticing even their fixed income investments can lose value.

Enter a service that allows you, the saver/lender, to become the bank and banker, and earn a yield higher than you may have earned on your portfolio over the past few years. In fact, the marketing materials from P2P companies are quick to point out that your portfolio may be down in recent years, making the returns you could earn by lending your savings via their website very attractive.

The idea itself is actually a pretty innovative one. Lower the costs of financial intermediation – or the internal costs of connecting a lender with a borrower – and thereby lower the interest rate to the borrower, and increase the returns for the lender.

Here’s how it works in a nutshell:

• You establish an account with a P2P company on their website and fund your account.
• You then search through users that want a loan, and do your research. On the sites you can view a potential borrower’s credit rating, existing debt, and you can communicate with the borrower to find out the purpose for the loan, and how they expect to pay your money back.
• You ‘bid’ on that loan by offering how much you will contribute to the overall amount being requested, and the minimum interest rate you are prepared to accept. Other bidders participate to bid up the loan amount and bid down the interest rate. If the loan has enough bidders to meet the amount requested that can agree on a common rate, the loan is filled. The borrower makes monthly payments of interest and principal, with the P2P company taking a portion as a service fee, and the rest goes back to the lender’s account.

So, what are the drawbacks? There are plenty.

Finding loans worth funding is difficult. Doing my own search, I found the time spent researching borrowers versus the potential profit and loss just wasn’t worth it. I rarely found many borrowers I felt good about lending to, and for the few dollars extra in potential interest, I was better keeping my money at the bank.

A very common loan request was the borrower who wanted to invest their loan proceeds into higher risk investments; such as high-yield mutual funds, or, in many cases, into other P2P loans. Basically, your loan was invested in a higher risk loan, and someone else was making the profit for risking your money. I was dumbfounded by all the lenders willing to take 5% from someone who only wanted to purchase junk bond mutual funds, their reasoning went something along the lines of the loan being a sure investment since the junk bond fund was “yielding 9%.”  

As P2P lending gains in popularity, other bad ideas to make it more accessible to the average saver are sure to spread. One such idea has already come in the way of ‘portfolio plans.’ These are automatic investment plans where you send in your money, and it is lent for you automatically into a portfolio of loans. You don’t have to do the research to find out you are loaning money to the entrepreneur who would like to establish Cigarette Stands outside the local schools, all of that work is all done for you. You just take on the risk of losing your savings.

Even if you are sold on trying out P2P lending for a profit, keep in mind the companies motivations here are often in conflict with yours. Their goal is to make loans, as they are paid fees only when loans are made. Sure, if a loan is bad and charged-off they lose some fee-income… but you lose your principal.

And it only makes sense that their marketing ignores that point. I’m viewing the site of Prosper.com at the moment. The message on the information pages is basically the same, no matter which of the 13 tabs you click: P2P lending can be a part of your retirement savings, and is a great substitute to stocks, CDs, money markets, etc.

All information or numbers seems to be making one of two points: 1) there are risks to investing in traditional investments, 2) there are benefits to P2P lending.

In fact, I had to do plenty of digging to find the default history of Prosper loans. Once Yahoo pointed me to where Prosper’s site index failed to, it was obvious why Prosper doesn’t advertise the risks of P2P lending as an investment.

As of June 8, 2009, company default experience for Prosper’s top credit grade was over 8.75%, and loan defaults over all credit tiers approached 20%.

Putting the potential returns and risk together, to lend to the top tier borrowers, you may earn 6-7% in interest before taxes, but be prepared to lose almost 9% of the time. Clearly when having all information on the risks, P2P loans are not an investment substitute for investors seeking stable cash flow.

My conclusion on P2P investing - for a speculative gamble, there are better places to lose your money; for an income generating investment, stay with investments that will guarantee to pay you an income.