The investment landscape has changed drastically over the past decade. Alternative, emerging forms of investing, such as cryptocurrency, have made it more important than ever for investors to do their due diligence before taking on the risk of these new investments.
One of the newest types of investing is peer-to-peer lending. This form of online investing involves companies connecting individual borrowers with lenders (called “investors”), bypassing traditional banks and financial institutions altogether.
Peer-to-peer lending can be risky if you’re not a keen, well-educated investor. Read on for everything you need to know about this unique lending platform.
What Is Peer-to-Peer Lending?
P2P lending platforms (such as Upstart, LendingClub, and Prosper Marketplace) promote that they can offer loans to borrowers at better interest rates than banks because they don’t have the overhead costs that accompany running a traditional bank. In turn, borrowers have access to unsecured personal loans and small business loans with interest rates that are typically better than what they can get from credit cards or personal loans from traditional banks.
The Borrower’s Side
Borrowers can go to P2P lenders for various loan purposes, just like they would at a traditional bank. According to LendingClub statistics, 45% of borrowers used their loan to refinance an existing loan, while 22% used their loan to pay of credit card debt. And 33% used their loan for other purposes, such as medical expenses and home improvement projects.
Loan amounts typically range from $2,000 to $40,000 on popular platforms like Prosper and LendingClub. Other companies, like Funding Circle, will offer higher loan amounts for small businesses while others, like SoFi, will offer student loan refinancing and mortgages with terms as long as 30 years.
When borrowers take out loans on a P2P platform, they will typically have a loan with a fixed interest rate and fixed repayment period (e.g. one, three, or five years, sometimes longer). The lending platform will assess a borrower’s credit risk based on their credit score, employment history, and other criteria. Once the loan is established, it will be split into smaller amounts that individual lenders can choose to invest in.
The Lender’s Side
Peer-to-peer lending platforms advertise that they can offer potentially lucrative investment returns to everyday P2P lenders (called “investors” because they invest in “notes”) who wouldn’t normally have the same level of access to the consumer lending world. Because these platforms don’t have the same overhead costs as banks, they claim that they can pass these savings on to investors. In addition, P2P lending platforms often say they can do as good of a job (if not better) as banks in assessing a borrower’s creditworthiness and risk. Many P2P lending platforms have their own analytical “secret sauce” when it comes to assessing risk.
Platforms like Lending Club or Prosper rate loans based on the risk of repayment, charging higher interest rates for loans they deem higher risk. Investors can choose how risky they want their investments to be — most platforms offer loans in a range of risk levels based on their analysis of the borrowers that apply — with a corresponding expected return for that level of risk. It’s important to keep in mind that because P2P lending involves unsecured loans, there is no protection for investors if a borrower defaults on their loan, although these platforms also pursue defaults like the banks do.
With most P2P platforms, you can invest a small amount of money (often as low as $25), though some platforms will require you to keep a minimum amount of money (say $1,000) in your account. You can choose from hundreds of thousands of borrowers with different needs, loan terms, and interest rates, which makes it possible to diversify your investments and therefore minimize your potential losses. Most peer-to-peer lenders charge fees.
The Borrower’s Side: What to Expect
First, you’ll complete an online application form. This is the biggest difference between a peer-to-peer lending platform and banks — you submit everything through the company’s website, and you never meet with an actual lender in person. You’ll need to provide the same information as you would to a bank when applying for a loan so the company can assess your creditworthiness. The criteria they’ll use to analyze your creditworthiness includes:
- Your credit score
- Your credit history
- Your debt-to-income ratio
- Employment verification
- The length of time you’ve lived at your current address
You’ll most likely also be asked what the purpose of the loan is, but the actual reason won’t matter too much. Whether you say it’s to finance your daughter’s dream wedding or to launch a small business won’t matter in the eyes of the lender so long as the hard numbers for everything check out.
If you’re approved for a loan, you’ll be offered choices for loan amounts and the number of years you’ll have to repay the loan. The higher your credit risk is to potential lenders, the higher your interest rate will be. Keep in mind that if you’re deemed a high credit risk, the amount you can borrow or the loan terms may vary.
If your loan is approved, you’ll receive your funds electronically. Typically, P2P lenders will charge an origination fee, which is the cost of matching you with lenders on the platform. The fee will be deducted from your loan amount. So if you borrowed $10,000 and the origination fee is 2%, the net amount you’ll receive is $9,800. (You’ll still have to repay the total $10,000 loan plus interest.)
Your loan will be broken into hundreds of smaller loans (say increments of $25), which investors can pick up as they’d like. Despite the fact that your loan may have many lenders, you still pay the P2P company directly each month.
One similarity between banks and P2P lending platforms is that neither looks kindly on missed or late payments. If you miss a payment or are late with payments, expect to be hit with fees and penalties. The P2P company will also likely report this negative information to the credit bureaus, which will impact your credit score.
One of the major benefits of borrowing from a P2P lender is that you’ll have a fixed loan term and fixed interest rate. This makes everything more predictable and easier to understand. In addition, there’s no verification of loan purposes. None of the lenders will actually verify that you’re using the money for what you say you are, like your daughter’s wedding. This can be a benefit, but it also means you need the financial discipline to use your borrowed funds wisely.
The Lender’s Side: What to Expect
Interested in the lending side of the P2P world? First, you’ll want to sign up online with one of the major companies. Prosper, LendingClub, Upstart, Funding Circle, CircleBack Lending, and Peerform are some of the biggest players in the industry.
Some P2P companies, such as Prosper and LendingClub, have minimum requirements to open an account ($25 and $100, respectively). Others, like Upstart, require their investors be accredited. Being accredited involves having a high income or high net worth based on criteria from the Security Exchange Commission (SEC).
As a lender/investor, the biggest risk to take into consideration is a borrower defaulting on their loan, which would result in you losing your principal investment. Because peer-to-peer lending, like most investments, carries some risk, it’s important to diversify your funds across hundreds or even thousands of borrowers.
Here’s an example for perspective: If you had $2,000 and you lent it all to one person, you’ve concentrated your risk. But if you break that amount into $25 loans among 80 different people, you’ve spread out your risk, as the chance of all 80 borrowers defaulting isn’t as high as the chance of one borrower defaulting.
Unfortunately, in the world of P2P lending, defaulting is to be expected. This is why it’s especially important to spread your investments across multiple loans. Ideally, the returns you get from the borrowers who pay you back with interest are intended to make up for the borrowers who don’t.
When it comes to selecting loans, you can choose based on risk “tiers,” which are also referred to as “levels” or “ratings.” These come with projected interest rates that are intended to appropriately compensate you for the level of risk you take. You can also choose different loan terms depending on your investing timeline.
As your loans get repaid by borrowers, you can either have the payments held in a cash account or you can have the P2P lending platform automatically reinvest the money based on your pre-set risk preferences.
Keep in mind that P2P lending does not carry as much liquidity as other forms of investments. Unlike having money in an interest-bearing bank account or even the stock market, you can’t get your money out easily once you’ve invested it in the P2P marketplace because of the loan terms. For example, let’s say you put your $2,000 into various P2P loans with one-year repayment terms. You will be repaid monthly over that year, but you won’t have access to your money in a pinch if you need it.
However, this means you’ll get your principal, or the amount you invested, back bit by bit each month, which many people would see as a benefit. Compare that with a one-year bond, for example, where you’d have to wait a full year to get your principal back, and you earn interest in six months or a year. With a P2P loan, however, the principal you lent gets repaid each month with interest.
Selecting a Peer-to-Peer Lending Company
Not sure which P2P company is right for you? Do some research that goes beyond simply looking at a few years of loan performance by asking the following questions:
- What is their track record like? How long have they been in business?
- What returns have they produced for their investors, and for how long? (Although note that past performance is not a guarantee that they are repeatable in the future.)
- How do they screen borrowers and monitor for repayment?
- What has been the default history in different economic conditions?
- Has the company been verified by an external source, such as a P2P watcher like Lend Academy?
Weigh the Pros and Cons
Peer-to-peer lending might be a nascent player in the world of investing, but the industry has matured since its inception over a decade ago. For borrowers, P2P lending can be a great way to get access to a consumer loan with a more attractive interest rate than one might find at a bank. For investors, P2P lending can be a way to dip your toes into consumer lending, which used to be the sole domain of big banks.
Interested in other forms of investing? Read this beginner’s guide to different types of investments to get started.