Peer-to-peer lending offers a new way to invest
As the financial world is becoming more democratized, transactions that were once only handled with banks as an intermediary are increasingly available using simple software platforms. From cryptocurrency to investment apps and robo-advisors, technology has presented savvy investors of all experience levels with a variety of ways to see returns on capital. One such option for investors — and one which can earn considerably higher interest than other investments — is peer-to-peer (P2P) lending.
P2P lending is proving to be one of the most popular new financial services as borrowers who have been denied loans from banks can find the money they need and investors can purchase part or all of a loan and see more of a return on their investment than they would by putting money in a savings account or buying bonds.
What is P2P lending?
Sometimes referred to as marketplace lending, P2P lending connects individual investors with individual borrowers. Investors on P2P lending platforms need to meet strict levels of income or net worth to be able to finance loans and are encouraged to diversify their investment by purchasing several smaller “notes.”
Notes are portions of a loan, sometimes as low as $25. Personal and business loans can be funded P2P and are unsecured, meaning there is no collateral. Loans are based on creditworthiness and interest rates are higher for borrowers with poor credit. Investors stand to make a bigger return but also assume more risk by financing loans that are given to borrowers with low credit scores who might not be reliable with payments.
Loans are also self-amortizing, meaning they have an established schedule of payments that will pay off the loan with interest by a specific time. As such, the amount of capital invested gradually decreases to zero, requiring the investor to purchase more notes in order to keep collecting interest on his or her money. Such a decrease is the key difference between investing in P2P loans and investing in bonds or CDs, where capital is invested up front and interest is continually collected.
Because the loans are often given to risky borrowers who have been denied loans at traditional banks, there is a chance that the loan will not be repaid. On most P2P lending platforms, investors have the choice of which loans they choose to fund, and the tendency is to choose the loans with the highest interest rates. However, borrowers are given high rates because they have lower credit scores and are therefore more likely to default on their loan.
Some P2P lending platforms have supports in place to assure investors that they will at least recover their initial investment if a loan goes into default, others charge investors a collection fee when recovering loans that have gone into default. Investors can limit their exposure to expenses and losses by: diversifying their notes across a variety of loans; favoring loans with lower interest rates; choosing loans that are being used for debt consolidation rather than purchases; and using a borrower’s debt-to-income ratio (DTI) to decide on which loans to fund.
P2P Lending Platforms
There are several options for borrowers and investors looking to get involved in P2P lending. Below is a list of a few of the most popular and what makes them stand out.
LendingClub – The largest P2P lender, having funded more than $45 billion in loans to more than 3 million customers, LendingClub offers up to $40,000 in personal and up to $400,000 in business loans. Investors need a minimum deposit of $1,000 to start investing and can either choose loans to fund on their own or have the process automated.
Prosper – Founded in 2005, Prosper is the original P2P lending platform and requires only $25 from investors to get started. Investors can choose from seven loan categories based on risk — AA has the lowest risk and sees an average interest return of 3.6 percent while HR has the highest risk and sees an average return of 9.2 percent.
Upstart – With an average income of over $80,000 for borrowers, Upstart boasts a high chance of investors seeing a return when the loan is paid off in timely payments — 89.3 percent of its loans are current or paid in full. Investors can create a customized investment plan or invest in an IRA.
Funding Circle – Funding Circle has provided over $9.5 billion in small business loans to creditworthy business owners looking to expand. Historical annual returns are 5 to 7 percent, offering sizable returns for those selected from the application process and willing to provide an initial investment of at least $25,000.
Picking the right P2P lending platform is as important as picking the right loans in which to invest. Fortunately, there are plenty to choose from and as the form of investment becomes more popular even more platforms will be created, tailored to specific types of investors.
As with any form of investing there is some inherent risk, but the possibility of sizable ROI is sure to appeal to investors looking for a convenient way to see their wealth grow.