When I think about lending money to friends and family, I cringe a little.

After all, lending to 'regular' people you know is fraught with emotional pitfalls as well as the possibility that you won't ever get your money back. And you usually don't even earn interest on such loans.

I'd much rather lend money to strangers -- and I do.

How is that possible? Well, I'm going to tell you in just a minute.

P2P Loans: How to Lend Money to (or Borrow From) Strangers

Banks lend money to strangers all the time, and they make a killing. Why can't I stand in the place of a bank, allowing ordinary borrowers to pay interest to me?

No, you don't have to start your own bank to lend money to others. There's a revolutionary way to earn great returns that may match those of stocks or bonds. It all hinges on your willingness to lend money to complete strangers. And here it is: peer-to-peer lending.

Over the course of the last few years, I've invested a portion of my portfolio in peer-to-peer (P2P) loans. P2P lending sites such as Lending Club and Prosper match investors (lenders) with borrowers.

How it works for the investor: Each loan is divided up into $25 increments, called notes. So, if someone wants to borrow $2,500, 100 people can help fund that loan. Because you are only risking a small amount of money on each loan, you aren't impacted as greatly if the borrower defaults.

How it works for the borrower: If the borrower is fully funded (and they have to be, to get any of the money), the funds are disbursed and the borrower begins making payments.

From there, the P2P lending site figures out the investor's portion of the principal and interest from each payment the borrower makes and deposits it into the investor's account. The investor can then choose to withdraw the money or reinvest it in other notes.

How P2P Loan Credit Ratings Affect the Loan's Interest Rate

Now, when you invest in P2P loans, you need to do your research -- just as you would with any other investment. Many P2P investors start out by sorting notes by credit rating. All borrowers are assigned a credit 'grade,' with 'A' as the best credit and 'F' or 'G' as the worst.

As with traditional loans, a borrower with good credit will pay less interest to the investor. A borrower with poor credit will pay more in interest to the investor, as the default risk is considered greater.

As with other investments, the higher the potential returns, the greater the risk. Most of my notes are invested in loans initiated by those with 'B' credit, although I also have some with 'C,' 'D,' or 'E' credit. I have also invested in those with 'A' credit. Interestingly, most of the write-offs I have are those with 'A' credit. It's one of the reasons I started shifting more of my notes to those with 'B' credit.

How Investors Can Reduce Their Risk on P2P Loans (Tips for Borrowers, Too!)

While credit ratings can help determine whether or not a borrower represents an acceptable risk, it isn't everything.

You should also read the stories associated with the borrowers. Look for borrowers who share the purpose of their loans and can articulate a plan for repaying the loan. I like to invest in notes from borrowers who plan to use the money to start businesses. I also occasionally invest in those consolidating relatively small amounts of debt; I consider large debt consolidation loans riskier -- even if the borrower has 'A' credit.

It makes sense to compose a P2P lending portfolio with a range of credit ratings, depending on your risk profile. Adding a portion of higher-risk notes to your P2P asset allocation can boost your overall returns, while lower-risk notes can provide you with a degree of stability.

How Well do P2P Loans Perform? How Much Return Can Investors Expect?

During the economic downturn and the stock market volatility following the financial crash, my P2P loans handily beat the stock market. And they certainly beat the returns from bonds and cash when the stock market began to really take off after 2013.

And while Treasury Bills were paying less than 2%, the average interest rate from Lending Club for an 'A' loan was 7.6%. If you are willing to take risk on someone with 'C' credit, the potential return jumps to 15.24%. If you're ready to give someone with 'F' credit a chance, you could see potential returns of 22.59%. But, even though that kind of return is likely to put stars in your eyes, remember that your risk of default is higher.

Investing in P2P loans, like any other investing, comes with risks. The most obvious risk is that of default. Lenders might not come through on the loan, and you could lose your remaining principal on top of the interest you would have earned.

Another risk is the illiquidity. You can't just sell your notes like you can sell stocks or shares in mutual funds. You have to wait until enough of your loans start paying out before you can even think of withdrawing money. If you invest in P2P loans, you need to accept that your money will be locked up.

For investors, P2P loans offer an interesting way to diversify your portfolio. You can even hold P2P loans in an IRA. Sign up with a well-known site like Prosper or Lending Club, and you can start earning reasonable returns by lending money to ordinary people.

For borrowers, P2P loans can be a great way to access to cash if traditional lenders won't pay up. If you have decent credit, you may also consider a low-interest personal loan, which can offer lower rates than credit cards and save you hundreds of dollars in interest charges.

See how to borrow cheaply without the risk of losing your car or home in The Top 4 Reasons to Get a Personal Loan.

Or, learn how to pay 0% on your purchases for up to 21 months with The Best Credit Cards for Balance Transfers.