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You've probably heard of peer-to-peer lending and wondering if you should invest in it. Some investors report remarkable returns with this investment strategy, but like any investment vehicle, peer-to-peer lending has both rewards and risks that you should be aware of.
In this article, we'll discuss what P2P lending is, how it works, the benefits and risks, as well as some other common questions so that you can decide whether or not you should invest in P2P lending.
Let's jump right in.
What is Peer-to-Peer Lending?
Peer-to-peer (P2P) lending is the process where individuals lend money directly to other individuals. P2P lending eliminates lending institutions, such as banks, and allows individuals who may not qualify for a bank loan to get a loan from a peer-to-peer network.
P2P lending became popular in 2005, making it a relatively new form of investing for those wanting to make money loaning their own money to others.
How does Investing in Peer-to-Peer Lending Work?
As an investor, you'll open an account at a P2P lending platform of your choice, such as at Prosper, and fund your account. You'll have the ability to see available notes on the platform in which you can invest money.
Depending on the P2P lending platform, different information will be available. On Prosper, each note will have basic information such as:
- The type of loan
- The total amount of the money requested
- The yield of the note
- How much has been funded so far
- How much time is left before the note has to be fully funded
Additionally, you'll be able to get further details on each note and read information about the borrower's credit profile. This information includes:
- FICO credit score range
- Number of credit delinquencies (present and in the past 7 years)
- Credit inquiries in the past six months
- Length of credit history
- Total credit lines
- Total revolving credit balance
- Credit card utilization percent
- If they have a mortgage
- Debt-to-income ratio
- Employment status, how long they've been employed, their profession, and salary range
Note, on other P2P lending platforms, the available information may differ. The above information was taken from Prosper, one of the major P2P lending platforms.
It's typical for P2P platforms to allow you to filter all available notes based on a criteria using the information above. For example, you may want to filter out any borrowers who are in too much debt or who are currently delinquent on one or more accounts.
After selecting one or more notes, you'll have the option of how much you wish to invest in each note. With Prosper, the minimum amount is $25, giving you the ability to divide your account into several $25 investments if you choose. Doing so helps mitigate losses if and when a borrower defaults.
As an example, say you invest $2,500 into your P2P lending account. You might choose to invest $25 into 100 different notes. By doing this, if 4% of your notes default – around the average default rate on some platforms – you'll have many other notes that are paying interest to cover your losses.
Your P2P lending platform may allow you to automatically invest all available money into notes based on a criteria you create, called a filter. That way, when you're paid out each month, instead of collecting your payments, you can reinvest the principal and interest automatically and grow your account more.
Notes generally last for 3 to 5 years, with repayment occurring in monthly installments. This means you start earning interest right from the first payment, which generally occurs around 30 days after the note is fully funded and lent out to the borrower.
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Is Peer-to-Peer Lending Safe?
Peer-to-peer lending isn't without risks. As an investor, if the person defaults on a note you've invested in, you'll likely not receive your money back. As a result, some experts recommend only investing a limited portion of your total investment portfolio in peer-to-peer lending to mitigate the risk of loss.
Popular Peer-to-Peer Lending Platforms
There are several popular P2P lending platforms available for you to choose from to invest, and these include:
Benefits of Peer-to-Peer Lending
Investing in P2P lending has several benefits, as we'll go over below.
High Potential Rate of Return
Possibly the most enticing benefit of investing in P2P lending is the high potential rate of return. Loan APRs range as low as 5% and as high as 25% and higher. Additionally, you can reinvest all of the interest you earn, which allows you to earn more money on the money you earn.
With high potential rates of return comes heightened risk. Generally speaking, notes with higher interest rates may be riskier to invest in, so it makes sense to balance your lending portfolio with less risky notes, which may be notes that have lower APR attached to them.
Low Cost of Entry
While each P2P lending platform has its own minimum amount of money to open an account, many of the platforms allow you to invest as little as $25 into each note. This means that once you've opened and funded an account, you're able to invest in additional notes with as little as $25. For those that invest regularly, this could mean that you invest $25 each time you get paid or in any other interval that you choose.
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Build Your Portfolio Based on Your Defined Parameters
A great aspect of investing in P2P lending is that you can craft a portfolio based on a criteria of your choosing. Typical platforms, like Prosper, allow you to filter notes in several ways so that you're only investing in ones that you align with your goals.
For example, you may have a conservative filter where you only invest in notes from people who have been at their job for more than 3 years, make a certain amount of income or more, have a moderate or lower credit utilization, and are not currently delinquent on any of their credit accounts. Of course, there are many ways you can configure your portfolio, and having that level of control can be inviting to someone wanting to invest.
Can Be Used as a Source of Passive Income
P2P lending is an excellent source of passive income as you'll receive interest payments each month along with that month's principal. You'll then have the choice to reinvest the interest or withdraw it to your bank account to use in other investments, cover expenses, or go towards something fun for you and your family, as some examples.
P2P lending platforms typically let you set up automatic reinvestments, meaning you can continually invest money as you earn principal and interest payments. This leads to investing on autopilot, which takes some of the manual work out of it. You'll set up parameters for how to invest the money, and the platform will take care of the rest.
Risks of Peer-to-Peer Lending
While P2P lending is a worthwhile investment avenue to earn money, it does come with risks, as we'll go over below.
Unsecured Loans Have a Risk of Default
When you invest in P2P loans, these loans are unsecured, meaning if the borrower stops paying and inevitably defaults, you likely won't get any remaining money back. So, if you invested $25 into a note, and after several months, $10 of that note had been paid back to you, but the borrower defaults, you are likely to lose the remaining $15. Of course, you will have collected interest payments from this note and all of your other notes to mitigate this loss.
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Fewer Options to Cash Out Early
It can be difficult to liquidate your notes before they mature. That means your money may be tied up for the entire term of the loan, less payments received back each month. Some platforms allow the selling of notes to other investors, but you are likely to give up some of the gains by doing this.
Because of this, you'll want to use money that you don't need access to right away when investing in P2P lending.
Relatively New Type of Investing with Limited Historical Data
P2P lending is a relatively new form of investing, meaning there's limited historical data on how this type of investment performs in varying market conditions such as a stock market or real estate market crash.
Limited data is a risk that you'll have to consider if you plan to invest in P2P lending.
How Do You Earn Money From Peer-to-Peer Lending?
You earn money with P2P lending when a borrower makes a loan payment each month. You'll earn principal and interest each time a payment is made.
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How Much Can You Make From Peer-to-Peer Lending?
The amount of money you can make with P2P lending depends on the rates of the notes you invest in, minus any money lost from notes that fall into default. Therefore, investing in notes with higher yields gives you a greater potential to earn money but may also increase your default rate.
Can You Lose Money From Peer-to-Peer Lending?
The risk exists that you'll lose money with P2P lending if a high percentage of your notes go into default. When investing in P2P lending, it makes sense to diversify your loan portfolio and invest only a portion of your total investments in this avenue.
Should I Invest in Peer-to-Peer Lending?
P2P lending can be a worthwhile investment strategy to add to your investment portfolio. However, as with any investment, you'll want to do as much research as you can before jumping in. Speaking to a financial advisor who understands the risks and rewards of P2P lending can be beneficial before you begin.
Wrapping It Up
P2P lending can be a lucrative investment strategy, but it's not without its risks. As mentioned earlier, doing plenty of research before investing in P2P lending will help you improve your returns and mitigate loss.