Investing: P2P Lending vs. Bank CDs

I'm going to start this post by stating something that is stupidly obvious: there are a huge number of different ways to invest your money.  From stocks and bonds, to investing in new companies, to burying your cash in the backyard, if you can imagine it, you can probably invest in it (dream a little dream, you dreamers!).  For the purposes of this article though, I'm only going to focus on two that I think have a good deal in common: peer to peer (P2P) lending and certificates of deposit (CDs).

How P2P Lending and CDs Are Similar

The key similarity both investments share is that both require you to tie up your money for a certain, specified amount of time.  As such, both are essentially illiquid investments.*  However, this length of time is fairly short-term, particularly when compared to 30 year bonds, for instance. 

For CDs, your money can be tied up anywhere between three months and five years, depending on how long you choose to invest.  For P2P, (which I'm basing on my experience with Lending Club, as I am unfamiliar with Prosper and others), your money is invested for either three years or five years.**

With the above similarity stated, let's look at the pros and cons of each investment.

CD Pros:

1. Your Money Is Very Safe - Most CDs are guaranteed by the FDIC, up to $250,000.  As such, even if the bank goes belly-up, the money you have invested is insured by the government (although if the government goes belly-up, perhaps you should have invested in automatic weaponry instead).
2. You Can Talk Face to Face with Real People - If you are the sort of person who likes to go into a bank to do business, certificate of deposits can be set up at any bank branch location (though you may find higher rates by buying a CD through on online bank).

CD Cons:

1. CDs Aren't Making Much Money Right Now - According to this search, the highest rate for a CD right now is 2.53%, and this is only available through a credit union reserved for Disney employees.  That CD also requires a five year commitment.  If you only want to invest for one year, the same search shows that you'll bring home closer to 1%.
2. CDs Require a Higher Minimum Investment - To open a CD, most banks require at least a thousand dollars to start out with.
3. Your Money Is Illiquid - I stated this before, and this will be a con also for P2P loans, but I can't state enough how you should not invest in either of these products if you'll need the money before the note matures.

P2P Pros:

1. The Potential for Higher Interest Rates - Even the most conservative portfolio at Lending Club will likely earn between 5-6%, and many people earn quite a bit more than that.***
2. The Pleasure of Not Dealing with Big Banks - With so much animosity towards Bank of America, Citibank, Chase, and others as a result of their part in the financial meltdown of our economy in 2008, investing through smaller companies like Lending Club and Prosper can help you avoid dealing with companies that you disagree with.
3. Lower Minimum Investment - If you're like me, and you'd like to test out this newer form of banking before plunging head-first, you can do so at Lending Club with as little as $25 to start out with.  However, the fewer notes you own, the greater the risk as each note makes up a larger portion of your portfolio.

P2p Cons:

1. You Take on More Risk - Sure, you might be making more money, but Lending Club notes are not FDIC insured.  If you invest all your money in notes for a particular loan (it is strongly encouraged to diversify your investment over many different loans), and the person who took out the loan skips town, you stand to lose your shirt (and possibly your house, wife, and kids).
2. Your Money Is Illiquid - Again, investing in this way ties your money up for a set amount of time (usually three or five years).

So, Which Investment Is for Me?

I personally don't have any money invested in CDs.  Even though my money would be very safe, the current dismal rates of return keep me from putting money there.  I do have some money invested in Lending Club, and I plan to continue investing there in the new year.

No, I Meant, Which Investment Is for ME!?

Oh, sorry about that.  Alternating between first, second, and third person gets confusing. :-)

Basically, it boils down to how risk averse you are.  If you are willing to accept sub-optimal returns in exchange for the security that comes with FDIC insurance, go with certificates of deposit.  However, if you're willing to accept a bit more risk for higher returns, perhaps it's time to expand your comfort zone into peer to peer lending.

For what it's worth, Lending Club just announced that it will not be taking fees out of loans greater than $20,000 for an unspecified amount of time, so now is potentially a good time to make the plunge.

Full Disclosure: I am an affiliate of Lending Club, and if you click and open an account through the ad at the top of the page, I will receive a commission.

*I say "essentially" because some are able to trade Lending Club notes on a secondary market, and you could cash out CDs prior to their maturity date, but doing so incurs a penalty.  As such, for the purposes of this article, I'm only focusing on what I consider the primary reason to invest in either product.
**"Three years or five years" assumes that the note is not paid off early.
***Some people do lose money however; make sure to research both the notes that you are thinking of investing in as well as P2P loans more prior to investing.

This post was featured in the Carnival of Retirement.