Peer to peer lending is one of the hot new ways to borrow (and invest!) money. It started a few years ago with lending club, but tons of new platforms have entered the scene, and it’s turned into an excellent alternative to traditional borrowing, especially for those who feel left behind by the banking system. It’s also an investment option for those looking to diversify their holdings.
What is Peer to Peer Lending?
Peer to Peer lending is a system where regular people lend money to other regular people. The platform you use is a middle man that collects the money, checks borrower’s credit, assigns risk, and keeps thing anonymous between lenders and borrowers.
How Does Peer to Peer Lending Work?
Peer to peer lending works by connecting borrows with lenders on an easy to use platform.
Borrowers apply for a loan by answering questions about credit worthiness (the questions and the process are a little bit different for each platform – but in general a credit check is required.). The platform will then issue a credit rating and open the loan up to investment.
Lenders on these platforms have a bit more flexibility. They can either sort through the loan requests manually and decide which they want to fund, or set up automatic investing based on their priorities and risk tolerance.
The best part for investors is that the risk is pooled. Most investors aren’t fully funding any individual loan. Hundreds of investors are each putting small amounts of money (as little $25 – but you can invest more if you want) towards each loan. This way, if one or two borrowers defaults, the investor isn’t losing out on her entire investment. You can think of it as being similar to an ETF for personal loans – you own small parts of tons of loans, which diversifies your portfolio and helps to minimize risk.
The great thing about this type of lending for both borrowers and investors is that the platform does most of the hard work for you. It finds lenders for borrowers, and it finds investments for lenders. It also handles all of the financial transactions.
How Much Does it Cost?
Nothing is free of course, and that is true for both borrowers and investors. Borrowers will pay an origination fee on most platforms (which is usually a percentage of the loan that gets rolled into the payments) while investors will pay a percentage of the returns. The cost is variable across platforms, so whether you are a lender or a borrow, it pays to shop around.
Can you Make Money with Peer to Peer Lending?
As an investor, there is the opportunity to make money with peer to peer lending. Like any investment, there is risk involved, however with greater risk comes a greater possibility of rewards. The estimated rate of return on peer to peer lending loans is a bit higher than traditional stock market returns. Borrowers generally pay between 5% and 20% interest depending on their credit.
It may seem exciting to look at that 20% and think you can get 20% returns, but let me tell you, that is risky! There is a reason the interest rate is so high, and that’s because they are most likely to default.
To play it safe, you can either focus on the A+ borrowers who are paying the lowest in interest, or you can diversify. Build your portfolio with a mixture of different types of borrowers. Balance out the risk verses the reward. If some default, you should still be able to make money on the others who don’t.
Is Peer to Peer Lending Safe?
This really depends on what you mean by safe. Of course, there are risks involved with any investment. In my opinion, it is riskier than investing in a traditional ETF (and probably has higher fees as well) because you are investing in individuals rather than companies.
But if you are asking whether it’s a scam or not, rest assured that it is not. Although it has its own set of risks, its not a scam. It is a legitimate system of investing and borrowing.
Are there any Restrictions?
There are tons of weird restrictions on different peer to peer lending platforms, which vary by state. Some states allow you to invest with no restrictions, and some states don’t allow you to invest at all. Some of these states allow you to invest on some platforms and not others. Check out this map of states to find out if your state allows investing.
Borrowing is a bit easier and less restricted. Most states allow their residents to borrow on most peer to peer lending platforms, but there still may be some restrictions, which you can find here (to be fair, its the same map as above – but hey, the thing is handy!).
The question “what is peer to peer lending” is generally the reason behind the restrictions. They are legally defined as securities, but aren’t included in any national exchanges. That means they had to be reviewed and listed by each state’s individual regulators. Some thought peer to peer lending was a great idea, while others thought it was too risky for its investors.
What are the Advantages of Peer to Peer Lending?
Borrowing with Peer to Peer Lending
It’s easy to see the advantages for borrowers. You can get a personal loan for tons of different reasons. Most borrowers are looking for debt consolidation loans, and the main advantage there is a lower interest rate and a single payment.
If you are interested in borrowing money with peer to peer lending, check out prosper. They have funded over 16 billion dollars in loans and offer flexible payback options. You can even check your rates with no obligation and no impact to your credit score!
Investing with Peer to Peer Lending
It seems like peer to peer lending has higher fees and is riskier than just throwing all of your money into an ETF. And you’re right, those things are true. But that doesn’t mean that there are no advantages.
One important advantage is that it’s a totally different type of investment, and that means diversification. Sure, most ETFs track the entire market, but you are still only investing in companies. Investing in people offers something a bit different.
Peer to Peer lending can also have higher returns than ETFs – but remember that it has higher risks as well. It might be a great option for those who enjoy higher stakes investing, but I definitely wouldn’t advise putting all your eggs in a P2P basket. I also wouldn’t recommend it for beginners. If you are a brand new investor, check out this guide for the best investments for you!
The final advantage, and in my opinion the biggest advantage, is that you get to help real people. There are people on these platforms that are trying to rebuild their lives, trying to crawl out of debt, or saving for a home. There are entrepreneurs trying to start businesses, and families trying to pay for medical expenses. Sure, they could put these expenses on credit cards, but they’d be paying out the wazoo in interest rates. Peer to Peer lending gives them the opportunity to do all of these things with lower interest rates and one manageable payment. As an investor, you get to help people and make a small return on the interest. It’s a win-win in my book.
Prosper is a great platform for investors as well. You can choose loans to invest in based on your level of risk, and their returns have been between 3.5 and 8 percent. Check them out today.
What Is Peer to Peer Lending?
I hope you have your answer. Peer to Peer lending is an awesome way for real people to lend money to other real people, minimizing risk to the greatest extent possible. Whether you are a borrower looking for a loan or an investor looking to diversify her portfolio, you should check it out today!
Melanie launched Partners in Fire in 2017 to document her quest for financial independence with a mix of finance, fun, and solving the world’s problems. She’s self educated in personal finance and passionate about fighting systematic problems that prevent others from achieving their own financial goals. She also loves travel, anthropology, gaming and her cats.