As of March 25, 2016, the average interest rate on money market and savings accounts was just 0.54%. The average rate on 3-year Treasuries was 1.01% and 1.36% for 5-year Treasuries. Certificates of Deposit (CD) aren’t offering much more, with a 1.33% rate on 1-year and 1.77% on 5-year CDs. Municipal and corporate bonds have similarly low yields.

The anticipated returns for the lowest-risk peer-to-peer (P2P) loans look great by comparison and they go up from there. P2P marketplace Prosper’s historical returns range from 5.48% for its lowest-risk investments to 11.35% on its highest-risk investments. Lending Club returns have a comparable range, from 5.24% to 9.3%. Upstart’s modeled returns show investors potentially earning 3.79% on the lowest-risk investments and up to 14.86% on the highest-risk ones. (For more, see Can You Earn 8% Investing In P2P Loans?)  

How It Works

First, a bit of background on peer-to-peer lending, which is also called marketplace lending, social lending or platform lending. It’s a system that lets individual and institutional investors fund loans directly to individual borrowers for purposes like credit card consolidation, education, home improvement and vacations. Companies like Lending Club and Prosper act as intermediaries between individual borrowers and lenders, handling record keeping, fund transfers, fee assessments and delinquent loans, among other tasks.  (For more, see Investing in (and with) Lending Club: How It Works.)

Investors earn passive income in the form of monthly principal and interest payments as borrowers repay their loans. The overall process isn’t entirely passive, though, as you’ll need to either do research to select your initial investments and reinvest the proceeds, or set up automatic investing based on your preferences.

Risks

Why is the interest rate so much higher with P2P loans than with fixed-income securities? It’s because you’re taking additional risks to earn that potentially higher return. What are those risks, and are they safe to take in retirement?

Default Risk

P2P loans are unsecured, like credit cards, and unsecured loans typically have a higher default risk than secured loans. In this situation, the only thing the borrower has to lose is some points on his or her credit score and possibly money in the form of collection fees. Unlike with a secured loan, such as a mortgage or auto loan, the borrower faces no risk of losing her home or car by defaulting on a P2P loan.

Make sure your potential returns are appropriate for the level of risk you’ll be taking on with the loan. Furthermore, if we experience another recession, default rates could go up, and your returns could be lower than you expected. Unlike stocks, where you can wait out a bear market and likely recoup your losses eventually, if a P2P borrower stops paying, you’re out of luck.

Lack of Insurance or Government Backing

Unlike a Treasury note or CD, you could lose principal with your P2P investments: These loans are not guaranteed or insured. While it’s generally considered safe to rely on the faith and credit of the U.S. government or the Federal Deposit Insurance Corporation, there’s nothing to fall back on if a P2P borrower defaults.

Interest Rate Risk

With the Federal Reserve planning to gradually push market interest rates higher in the coming years, borrowers may have to pay higher interest rates, potentially resulting in higher returns for investors. If the rates of return on other investments rise faster than the rates of return on P2P investments, the latter could become less desirable.

Keep that in mind when you select any loans you take on. As with choosing a CD term, you may want to choose the 36-month P2P loans over the 60-month ones if you think interest rates will keep climbing. (For more, see How Federal Open Market Committee Meetings Drive Rates and Stocks.)

Liquidity Risk

If you want to unload part or all of your P2P portfolio for whatever reason, it won’t be as easy as if you wanted to unload some Apple Inc. stock or shares of a popular exchange-traded fund. And unlike with CDs, you can’t just pay a withdrawal penalty and get your principal back along with most of the interest you’ve earned. Instead, you’ll have to use a separate platform called FOLIO Investing. You’ll pay a 1% transaction fee and likely lose part of the value of your notes, since secondary buyers will expect to purchase them at a discount.

Mitigating the Risks

The following strategies will mitigate the risks of investing part of your retirement nest egg in peer-to-peer loans. You’ll need to decide whether these strategies take enough of the edge off to make you comfortable with this investment.

You don’t have to put it all your money into one loan. Instead, you can allocate as little as $25 apiece to multiple loans. If you do that and one borrower defaults, you’re only out $25 at most on that single loan. This is much less risky than taking a chance on lending $1,000 to a single borrower. Based on Lending Club’s historical returns and default rates, if you invest $25 each in at least 100 loans, you’re unlikely to lose money.

Treating P2P Investing as a Hobby

P2P lending is a high-risk way to generate a steady monthly income in retirement. To earn $5,000 a month from P2P lending, you’d have to invest more than half a million dollars in higher-risk investments and earn an 11.3% return. Given that you could potentially lose all your principal, this is too much risk for most retirees.

Instead, you may want to think of peer-to-peer investing as a fun hobby that you pursue only with money you can afford to lose, much like day trading. (For more, see I’m Retired: Is It Safe to Invest in the Technology Sector?)

The Bottom Line

There are many reasons to consider investing in peer-to-peer lending in retirement. With more free time that can be used to conduct research, you can consider alternative investments you may not have had time to fuss with while you were working. In addition, you may get a sense of personal satisfaction from lending money to individuals instead of investing in large companies and governments. Perhaps you’ll enjoy the social aspect of peer-to-peer lending – participating in online forums where other investors share their experiences and strategies. You may also value the intellectual challenge of learning about and gaining experience with a new asset class.

Still, you need to assess the risks carefully and make sure peer-to-peer lending fits into your overall financial plan for maximizing returns and minimizing risk so that you’re financially and emotionally comfortable during your retirement. P2P loans are most appropriate for retirees who are fine with higher risk and can afford to lose their principal. If you can’t sleep at night unless all your money is in bonds and CDs, peer-to-peer investing isn’t for you.