In a few months it will be five years since the Federal Reserve lowered interest rates to zero. I don’t think anyone could have predicted rates would be this low for so long. While the stock market has been hitting new highs recently the rates for fixed income investments have remained at historic lows. People looking for income producing investments have had few options.
It is against this backdrop that p2p lending has come of age. It is relatively easy to sell investors on the idea of 8-10% returns when there are so few options for returns like this elsewhere. But what happens when interest rates rise and FDIC-insured investments are returning 5% or more? It makes little sense to invest in an unsecured loan that is paying 6% when you can get an equivalent return with no risk.
What will happen to the interest rates for p2p lending in a higher interest rate environment? While I don’t have the definitive answer (no one does) I can provide my own theory.
Borrowers have shown a capacity to continue borrowing in any economic cycle. There will still be demand, of that I am confident. But interest rates will have to change. Right now the lowest interest rate available at Lending Club is 6.03%, at Prosper the lowest rate is 6.04%. And herein lies the problem. The expected return to investors for these loans (after expected losses and service charges) is going to be between 4% and 5%.
That is not a bad return today but when FDIC-insured investments return 5% it starts to look unattractive. So rates will have to go up in order to attract investors. If the Federal Funds Rate goes to 5% again I think we will see borrower interest rates begin at around 8% to ensure a return to investors of 6% to 6.5%.
Will this mean the most creditworthy borrowers will look elsewhere? Possibly. But keep in mind other borrowing options will also be more expensive.
So, I believe that the impact of higher interest rates will not be that dramatic for p2p investors. We might see a slight increase of the average risk profile for the most creditworthy borrowers but apart from that I don’t foresee any major changes.
What do you think will happen if interest rates begin to rise? As always I am interested to hear your comments.