Peer-to-Peer Lending Can Be a Smart Bet I'm not much of a risk-taker when it comes to investing. I live by the old adage, "Be wary of investments you don't understand." That limits a lot of my options. Plus, I've been writing about personal finance for almost seven years now. I've learned how the markets work. And for the most part, they seem to work by milking average investors like you and me of our hard-earned money. (Don't believe me? Read the Pulitzer-prize winning Den of Thieves; it'll make you never trust a banker or broker again.) For the past few years, all of my investments have been in two things: municipal bonds and index funds. These are investments I understand. They're investments with very little "drag" - there aren't a lot of brokerage fees being skimmed off the top before I get my share. I'll never earn spectacular returns, but I feel confident that I'm never going to suffer catastrophic losses either. Lately, though, another investment option has caught my eye: peer-to-peer (P2P) lending. P2P lending basically works like this: Somebody who needs to borrow money goes to a company like Prosper or Lending Club and applies for credit. Once approved, the borrower is assigned to a risk category, which determines the interest rate of the loan (s) he or she receives. Then, that loan is funded by an individual investor (or group of investors) who acts as the lender. This turns out to be a good deal for borrowers because they get a better interest rate than they might through a traditional bank loan or credit card. But it's also a good deal for lenders because they earn a higher return than they can through a savings account or certificate of deposit. And, of course, it's a good deal for the company arranging the loan because it skims money off every transaction. P2P lending has been around for six or seven years, but I've always been wary of it until now. Over the past few months, I've talked with several other financial writers who have begun to experiment with P2P lending. Like me, they're cautiously optimistic about the potential returns. Recently, on a trip to San Francisco, I had a chance to stop by the headquarters of Lending Club, the largest P2P company in the U.S. Earlier this month, they reached one billion dollars of loans funded. I spoke with the company's CEO and founder, Renaud Laplanche, about why I should put my money into P2P loans. "We focus on providing good terms to borrowers with good credit rather than chasing borrowers with bad credit," Laplanche told me. We decline over 90% of the loan applications we receive. That's the price we pay to deliver predictable performance to investors. Laplanche told me that P2P lending - at least through his company - has less volatility than the stock market. The ups and downs aren't nearly as nerve-wracking. But the price you pay is a lack of liquidity; you can't just sell your notes the way you might sell a stock or mutual fund. (MORE: New Low For Flying? Standing-Room Only Flights Possible) And if I invest some of my money in P2P loans, how will the poor economy affect performance? Laplanche says Lending Club weathered the market crash of 2008-2009 just fine. The main macroeconomic factor that has an impact on investors is the unemployment rate. More specifically, the rate of job loss. In other words, if unemployment is increasing, borrower default rates increase and investor returns decrease. My main concern is putting all of my money into a handful of loans. If one borrower defaults, I'm screwed. Laplanche assured me that isn't a problem. "It's quite simple to achieve diversification," he said. Our website automates the process. In fact, he told me that no investor who has ever taken out more than 800 notes (at $25 each) has ever lost money. "If you can't reach the 800 note threshold, even 400 notes or 200 notes is good diversification," Laplanche said. I haven't moved any of my money from mutual funds to P2P loans yet. But I will. Right now, I'm buying a house. When that process is finished, one of my goals for the new year will be to build a portfolio of P2P loans. Not only do the returns seem promising, but they're an investment I can understand. And to me, that's almost as important.