What Is Peer to Peer Lending?

If you've ever looked into the idea of investing in something a little cooler than the stock market, you've probably come across the term “peer-to-peer lending.” And for those of you wondering what is peer to peer lending, you're in the right place.

Even though it sounds like a group of suits exchanging a few hundred bucks at a golf outing, but it's a little more sophisticated than that.

Peer-to-peer lending (or P2P, for short) lets investors lend money to consumers who are in the market for unsecured loans.

These investors are usually regular, albeit fairly well-off folks, someone who might not be a Wall Street banker but has an extra $10,000 sitting around and wants to invest it in something more interesting than traditional stocks and bonds.

Basically, it's a way for people who need money to borrow from regular people instead of from giant financial institutions.

It's pretty great, and if you know what you're doing, you can make some big returns on your smart investments. Here's how.

What is Peer to Peer Lending?

Peer to Peer lending is an investment opportunity in which you lend to borrowers through an intermediary company, which vets loans requests and services the loans in exchange for a fee.

You can think of it as something bridging the gap between private lending and traditional loans.

You make your investments as individual loans to specific borrowers, who repay principal plus interest over time according to the agreement.

Companies Involved

There are several P2P lending mediators operating in the United States, split between those open to individual investors without accreditation and those only open to accredited investors with enough net worth or annual income.

To invest on either site, a net worth of $250,000 or more or a gross annual income of at least $70,000 is typically required.

You also have to live in a state that permits residents to invest in P2P lending.

If you live in Alaska, Michigan, Missouri, Oregon or South Carolina, you can't use Lending Club but you can use Prosper. You can check out the full state map here.

The most well-known are Lending Club and Prosper, although there are many popping up here in the United States and abroad. Including Upstart, a new one I love.

Legal Considerations

Beyond the specific rules companies lay out for joining as an investor, some states place limitations on participation in P2P lending.

The exact stipulations of the law and status of the companies involved can open and close different doors as a potential investor.

You may find that you can only invest in P2P lending through certain companies, or that you need a certain level of income or net worth to participate at all.

Tax Considerations

Under most circumstances, income from peer to peer lending will be treated as taxable income and must be paid for accordingly.

The primary exception is the use of retirement accounts, with some companies assisting in the creation and maintenance of 401(k) and IRAs to minimize taxes on your lending returns.

In fact, I keep getting emails from Lending Club encouraging me to set up an IRA there and offering me a pretty sizable bonus to do so.

You’ll want good accounting in place, as you’re still liable for taxes for any specific lending returns that aren’t big enough to warrant individual 1099s from the lending companies.

How Safe is It?

While P2P lending isn’t a secured, FDIC-insured form of debt, the notable P2P lending companies perform thorough credit checks and identify confirmation, resulting in high-quality, reliable borrowers.

Default rates hover around 4% across Prosper and Lending Club, while Upstart still reports almost no defaults.

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Assessing P2P Investments

The strength of the opportunity provided by P2P investment is, of course, proportional to the amount of control over your investments you retain; if you want your P2P investments to show worthwhile returns, you need to learn how to accurately assess opportunities and capitalize on those which are worthwhile.

There are a number of factors you’ll want to consider:

Loan Amounts

Loans in peer to peer lending fall on the smaller side of private lending, with personal loans capping at $35,000 and business loans capping at $300,000 or $500,000, depending on the mediating company.

Different companies assess and score borrowers differently, though each takes into account borrower credit scores, history, and ability to repay.

Risk vs. Yield

As with any investment, higher risk correlates to higher potential returns.

Peer to peer lending offers a straightforward codifying of risk vs. yield, scoring loans A through G according to risk factor, with most platforms setting firm limits on loan amounts for higher-risk borrowers.

This also means investors with more capital can’t use P2P lending as an alternative investment roulette, letting everything ride on a few high-risk high-reward opportunities. The key is to spread it around across a LOT of notes.

Diversity

The key here is to ensure diversity across your note portfolio.

If you have $2,000 to invest, then you can buy 80 loan portions in $25 increments instead of putting all $2,000 in one loan.

This mitigates the default rate across your portfolio.

Fees

It’s important to take company-specific fees into consideration when assessing any potential P2P loan.

Most of the major P2P lending companies draw 1% monthly fees, but there’s quite a bit of variation if you look for it.

Depending on the specific types of loans you’re looking to invest in and your status as an independent or accredited investor, you may be able to find a much better deal with a little legwork.

Defaults, Late Payments, and Chargebacks

The handling of funds acquired after late payments, chargebacks, and defaults vary quite a bit across P2P lending companies.

Lending Club, for example, differentiates between payments collected with and without litigation, while Prosper will deduct a flat 40% of recovered monies.

It’s important that you take the potential handling of these funds into account when assessing a particular loan, as it can wildly impact your final returns if a loan goes bad.

P2P lending vs. other investments

Finally, let’s take a look at how P2P lending stacks up.

After all, the draw of alternative investments is the promise of superior profits; if you can’t achieve better returns through close management of your P2P investments than you would stuffing your money in a mainstream investment and forgetting about it, there’s not much point to it.

Current Stats

The return on P2P lending investments float between 6% and 10%, with a median return between 7% and 8%.

The returns and reliability of the system exceeds many alternative investment and mainstream investment opportunities, as evidenced by the rapid growth of institutional investment in P2P lending.

Between 2010 and 2015, the industry went from pure self-managed independent investment to a 28/49/23 split of institutional investment, managed individual investments, and self-managed independents.

Comparisons

Traditional investment avenues are underperforming across the board.

Savings accounts, money markets, and bonds are all struggling to break 2%.

Record-high stock markets at 7% look impressive on paper, but closer analysis shows investors earning under 4% in most cases.

With P2P lenders in the bottom 10% nearing 6% returns, it’s easy to understand why P2P lending investment has seen such a surge of interest.

Drawbacks

The primary drawback of P2P lending lays in its liquidity.

Your borrower will usually immediately spend the money, once you’ve invested.

You’ll need to wait for your monthly payments to get money back out of the investment.

There’s no way to pull your funds back.

It’s also difficult to invest large amounts of capital into P2P lending, simply because of how granular the lending process is.

It’s simply not feasible to do your due diligence on a huge number of peer to peer loans.

Growth

Debt remains a growth industry in the United States, with the most exciting new potential laying in smaller scale loans such as those most frequently seen in P2P lending.

The granularity, flexibility, and diversity of possible loans make this a ripe field for investors willing to put time into managing their money and seeking their own opportunities, and nearly as valuable for those working through intermediary managers and institutions.

P2P lending is also notable as a debt-based investment with legitimacy other alternative investments based in debt lack, giving it a surer foothold moving forward.

Parting Thoughts

If the lack of liquidity or requisite attention to detail doesn’t drive you away, peer to peer lending looks to be one of the most efficient, effective investment routes out there.

Its place as a healthy niche in the lending industry ensures its long-term viability and stability when compared with some other high-value, alternative income investment channels.

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