At a time when more institutional lenders are dominating peer-to-peer lending, it’s important for everyday investors to understand how they are investing.

“Investor performance is coming down for peer-to-peer loans because there’s a growing number of charge-offs where a bank or a lender can’t collect on the loan and then the loan is deemed worthless,” says Colin Plunkett, equity research analyst at Morningstar in Chicago.

Plunkett cites Lending Club Corp. (ticker: LC), whose annualized charge-off rates increased from 4.2 percent to 6.2 percent in the personal loans-standard program and 5.9 percent to 11 percent for the personal loans-custom loans program from September 2015 to September 2016.

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“The charge-off rates have really increased over the last year,” Plunkett says. “It appears they had more charge-off rates than they anticipated and it increased their interest rates because they didn’t lend correctly.”

Sid Jajodia, chief investment officer at Lending Club in San Francisco, says the lender updated its credit policy to tighten its thresholds to stabilize delinquency rates by not lending to as many borrowers who had high debt-to-income ratios and other risk factors. The standard loan program that includes borrowers with a FICO score of 660 and above is open to institutional and retail investors, but the custom loan program, which includes a riskier pool of borrowers with a FICO score of 600-659, is open only to institutional investors, Jajodia says.

“We surgically cut out a small portion of the population we thought investors shouldn’t be exposed to,” Jajodia says.

Lending Club assigns a grade, A to G to each loan based on the credit quality and risk attributes of the borrower. Plunkett says while Lending Club does disclose a FICO score range of individual borrowers, it doesn’t disclose the average FICO score by grade, which he says makes it hard to tell what the entire loan pool looks like.

“To me that’s a pretty big red flag,” he says. “If you can’t tell what FICO score an A [group loan] represents, it’s challenging to determine the overall risk of the entire loan portfolio.”

Jajodia says once investors register they can access Lending Club’s data of every loan — more than 1 million — that originated in the standard program, including the borrower’s FICO score and the debt-to-income ratio. According to Lending Club’s latest 8K filed Jan. 18, the average interest rate for a 35-month loan ranged from 6.98 percent for a low-risk “A” loan to 30.89 percent for a “G” loan.

Investors need to decide if the borrowers have the long-term credit ability and a willingness to repay versus what was projected when the security was initially priced, says Burke Dempsey, managing director of investment banking at Wedbush Securities in New York. They also need to examine the trustworthiness of the loan originator and if that lending company has “the integrity and commitment to deliver a transparent and quality product to all parties, especially under pressure of high growth or a turn in the economy,” he says.

Plunkett says it’s also important for investors to consider how a company makes its money. A key difference between Social Finance and Lending Club is how the companies maintain their balance sheets, he says.

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“SoFi keeps a portion of the loans they make on their balance sheet since the company itself invests in these loans,” Plunkett says. “That totally changes the incentive structure, because Lending Club is incentivized to make as many loans as possible, SoFi not only makes money off making the loans but by investing in the overall performance of those loans, which makes it a much more sustainable model and eliminates conflicts of interests that are similar to what mortgage brokers had in 2008.”

Lynda Livingston, professor of finance at University of Puget Sound in Tacoma, Washington, says investors should also be aware that the term peer-to-peer lending is a bit of a misnomer since most loans are being administered by institutional investors.

“Big banks have algorithms to access credit risk,” says Livingston, who oversees Four Horsemen Investments, a nonprofit peer-to-peer lending firm that is managed by college students and uses Lending Club.

“There’s not enough transparency as platforms have evolved,” she says. “They aren’t allowing you to contact or discuss questions with the borrowers. Everything is filtered through the platform and standardized, so it’s very hard, if not impossible, to weed out the good from the bad. The best loans are getting skimmed off the top by institutional investors.”

Livingston says when Four Horsemen Investments started in 2009 there was more interaction between the borrower and investor.

“Originally the borrower would write up a story, have a picture and you could ask them questions,” she says. “Prosper [Marketplace] really encouraged its lenders to ask questions of the borrowers for relational lending. That’s how you could have someone who was not at a bank who could make a good loan, you could do your own legwork, but you can’t do that anymore.”

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Andrew Crosby, a senior at the University of Puget Sound and president of Four Horsemen, says the nonprofit switched from using Prosper, after experiencing a 12.21 percent default rate, to Lending Club, which has netted an 8.38 percent default rate.

Both Crosby and Livingston say they’ve also seen the industry migrate from offering loans for weddings, home improvement and college tuition to narrowly focusing on debt consolidation.

In the past 10 months, Livingston says many of Four Horsemen peer-to-peer investments had borrowers default.

“I don’t know if we are having more defaults because the loans are older or because they’ve fundamentally changed,” she says. “We have more and more defaults these days and it seems that the loans are becoming fundamentally more risky, especially the ones available to small investors.”

Lending Club’s Jajodia says the marketplace is designed to distribute and give individual and institutional investors equal access to the same types of loans.

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What Investors Need to Know About Peer-to-Peer Lending originally appeared on usnews.com