Peer-to-peer lending is a system in which regular people lend money to other regular people. You borrow from and lend to your peers when you use these platforms.
It's an alternative to traditional borrowing for people who feel left behind by the banking system and an investment option for folks who wish to diversify their holdings (and perhaps help a fellow human being).
How Does Peer-to-Peer Lending Work?
Peer-to-peer lending works by connecting borrowers with lenders. The platform serves as a middleman, which collects the money, checks credit scores, evaluates risk, assigns a credit rating, and ensures anonymity between borrowers and lenders.
How To Borrow with P2P
Borrowers apply for a loan by answering questions about creditworthiness (the process varies depending on which platform you use, but a credit check is generally required). The platform will then issue a credit rating and open the loan for investment.
Many platforms have borrower restrictions. Though the standards vary, most won’t allow users with low credit ratings to access loans.
Investing on P2P Platforms
Lenders on these platforms have more flexibility. They can either manually sort through the loan requests 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 as $25 – but you can invest more if you want) towards each loan. This way, if one or two borrowers default, 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 P2P Lending Cost?
Of course, nothing is free, and this is true for both borrowers and investors. On most platforms, borrowers pay an origination fee (which is usually a percentage of the loan that gets rolled into the payments), while investors pay a percentage of the returns.
The cost varies across platforms, so it pays to shop around whether you are a lender or a borrower.
Can You Make Money with Peer-to-Peer Lending?
As an investor, you can make money with peer-to-peer lending. Like any investment, it carries risk; however, with greater risk comes a greater possibility of rewards.
The estimated rate of return on peer-to-peer lending loans is slightly higher than traditional stock market returns. Depending on their credit rating, borrowers generally pay between 5% and 20% interest.
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 focus on the A+ borrowers paying the lowest interest and diversify.
Build your portfolio with a mixture of different types of borrowers. Balance out the risk versus 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?
Every investment comes with risk. I think Peer-to-peer lending is riskier than investing in a traditional ETF (and has higher fees as well) because you are investing in individuals rather than companies. Individuals are more likely to default.
But if you are wondering whether it’s a scam, rest assured that it is not. Although it has its own set of risks, it is 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 without restrictions, and some don’t. Some of these states will enable you to invest on some platforms and not others. You must do your due diligence before investing to determine the restrictions in your state.
Borrowing has fewer restrictions. Most states allow their residents to borrow on most peer-to-peer lending platforms, but some restrictions may still apply.
The question “What is peer-to-peer lending?” is generally the reason behind the restrictions. Peer-to-peer lending is legally defined as “securities” but is not included in national exchanges. That means each state’s regulators had to review and list it. Some thought it was a great idea, while others thought it was too risky for its investors.
What are the Advantages of Peer to Peer Lending?
Peer-to-peer lending has numerous advantages for both borrowers and investors.
Advantages to Borrowers
Peer-to-peer platforms provide numerous benefits for borrowers. They can apply for a personal loan for nearly any reason under the sun.
Most borrowers use these platforms for debt consolidation loans, which offer them a lower interest rate and single payment on their debts. However, the beauty of peer-to-peer is that borrowers can use the loan for nearly anything. You’ll find applicants hoping to fund vacations, weddings, home improvement projects, vehicles, and more on the platform - all for a lower interest rate than credit cards offer.
Advantages to Lenders
Peer-to-peer lending has higher fees and more risk than investing all of your money in an index fund, but that doesn’t mean there are no advantages.
The biggest pro for lenders is that it’s a totally different type of investment, so it provides diversification. Sure, most index funds track the entire market, but they only invest in companies. Investing in people offers something a bit different.
Peer-to-peer lending can also offer higher returns than index funds, but remember that it also has higher risks. 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.
The most significant advantage is that you get to help real people. Some people on these platforms are trying to rebuild their lives, crawl out of debt, or save for a home. Entrepreneurs are trying to start businesses, and families are 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 allows them to do all 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.
Who Shouldn’t Use P2P?
New investors should avoid P2P lending. It’s higher risk and more complex than index fund investing. If you’re just beginning your investment journey, check out our investment guide for beginners to determine which options are best for you.
Peer-To-Peer Lending Has Its Place
Peer-to-peer lending is a fantastic 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 your portfolio, you should check it out today!
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