How Does Peer-to-Peer Lending Work?
As an investor, it’s a good idea to explore different ways to make money other than the stock market or real estate.
One strategy you may not have considered yet is peer-to-peer (P2P) lending, which is becoming increasingly popular among investors.
This article explores how peer-to-peer lending works, why consumers love it, and how you could potentially make money by participating in P2P lending networks.
What is peer-to-peer lending?
Peer-to-peer lending involves individual investors issuing direct loans to individuals or small businesses.
When issuing a personal loan, you simply find someone who needs a loan using an online platform, determine whether they are a trustworthy borrower based on their credit score and borrowing history, and issue them a loan with the agreement they will pay you back with interest.
This type of lending eliminates the use of traditional banks. As such, there is no need to worry about arranging any appointments or getting paperwork together unless you decide to become an accredited investor.
Why borrowers like peer-to-peer lending
In the past, individuals and business owners basically had two options for securing personal financing. They could go to a financial institution like a bank or credit union for help or ask their personal connections for money.
Both options were difficult and risky. After all, nobody likes asking friends or family for money to fund a personal initiative. There’s always the chance an investment could backfire, after all.
Through this lens, peer-to-peer lending is a game-changer. This is because it enables people to connect with individual investors over the internet, thereby removing a lot of the regulatory hurdles and awkwardness of asking for money.
Essentially, P2P lending gives random people the opportunity to connect and transfer funds for various purposes.
Borrowers can use peer-to-peer funding for a variety of purposes, including:
- Buying a car
- Making capital upgrades on an investment property
- Launching a small business
- Consolidating credit card debt
How lenders benefit from peer-to-peer lending
At this point, you’re probably thinking peer-to-peer lending sounds great. But you might be wondering how it can benefit you specifically as a P2P lender.
Here are some of the top benefits that come with issuing peer-to-peer loans.
One of the best parts about issuing a P2P loan is that you don’t have to fund a whole loan. Just like you can now buy fractional shares of stock, you can now fund part of a loan, too.
Suppose someone needs $2,000 but you only have $100 to invest. You could buy $100 or less of individual notes, enabling you to invest with less money.
Interest rates can range anywhere from 5% to 20% or more on a P2P lending platform, meaning you could generate high returns from your investments.
That being the case, it’s possible to outperform other investments in your portfolio by issuing peer-to-peer loans.
Investors are often advised to build diverse portfolios with a healthy balance of stable and riskier—or growth-oriented—investments.
Investing in peer-to-peer lending is a great way to diversify your portfolio, enabling you to maximize growth and increase profits. You can use peer-to-peer lending while investing in stocks, bonds, index funds, mutual funds, exchange-traded funds (ETFs), and real estate.
Investing in peer-to-peer lending can also provide passive income, meaning you’ll receive payments without having to do anything.
Passive income is one of the top ways to build wealth. One of the secrets to building wealth is to put your money into vehicles that will generate recurring payments without requiring you to spend much time managing the investment.
Are peer-to-peer loans similar to investing in bonds?
Issuing a personal loan is a bit like investing in a bond in that you’re essentially purchasing debt. In return, you have the opportunity to have the debt paid back in full along with interest.
The main difference between a bond and a peer-to-peer loan is the level of risk that comes with the investment.
Bonds carry varying levels of risk. Bonds issued by the federal government are almost risk-free. Even corporate bonds, though slightly riskier, are still a relatively safe bet. Junk bonds, on the other hand, might be a bit riskier.
Peer-to-peer lending is different because you’re issuing loans directly to individuals. So, the risk is often two-fold.
First, you have to trust that the individual is reputable and in a position to make good on their loan. However, you also have to believe in the reason they’re borrowing the money in the first place.
If you give someone a $10,000 loan to start a business and it tanks, you may not get your money back in full.
Best sites for issuing P2P loans
Now that you understand peer-to-peer lending, let’s take a look at what you can do to get started.
P2P lenders have to find a third-party platform—essentially a middleman.
A peer-to-peer lending platform charges fees in exchange for partnering lenders with borrowers. However, these platforms can be very useful.
Lenders tend to offer robust online platforms for managing transactions and tools for understanding to whom you’re giving money and how they’re using the money.
Getting started in peer-to-peer lending is relatively simple and requires finding a P2P platform that offers low-cost management and a great user experience. With that in mind, let’s take a look at some of the most common platforms on the market.
Prosper now offers Prosper Invest, a mobile app that lets you manage investments on the go for quick and easy access.
Prosper offers historical returns of 5.4%. The company also has a reasonable minimum investment of just $25, meaning you don’t have to have a lot of money to get started.
In addition, Prosper offers the option to select individual loans or use their auto-invest tool for a more hands-off approach. So, if you’re the type who would rather sit back and have a platform manage your investments for you, you can take that approach.
2. Funding Circle
You may feel better about investing in small businesses than individuals. If so, head over to Funding Circle to invest in American small businesses.
This company specializes in helping creditworthy small businesses obtain financing through investors like you.
The process is straightforward: Create an account through Funding Circle and fund it. Then, use their auto-invest tool or pick opportunities yourself in their marketplace.
The minimum to invest is $500 for each fractional note.
Upstart enables investors to obtain peer-to-peer loans to pay off credit cards, consolidate loans, buy cars, relocate, and more.
The platform makes it much easier for folks to secure up to $50,000 in financing than traditional banks, and 99% of loans are funded the next day. Plus, unlike a traditional personal loan, Upstart doesn’t charge prepayment penalties.
Peerform is only for accredited investors—those with high net worth or impressive income.
To qualify, your income needs to exceed $200,000 (individually) or $300,000 (with a spouse) for two years. Or you have to have a net worth exceeding $1 million.
As such, Peerform is not for beginner investors. You have to demonstrate market proficiency to get accepted into the Peerform community.
Another platform to look into is Kiva, which is a platform that encourages financial inclusivity and promises investing with the power to improve or change lives. You can make investments of $25 or more on this platform.
Borrowers eventually make repayment on their loans, and you can use the money to either fund new loans, donate to charitable causes, or withdraw your cash.
The nice part about Kiva is that it has global reach, as the company works in 77 countries. According to the company, Kiva has supported over 282,000 borrowers in conflict zones, over 1 million borrowers in the least developed countries, and almost 1 million farmers.
For more information on Kiva, check out their impact section section.
Tips for issuing peer-to-peer loans
Don’t go overboard
If you’re new to investing, it may be tempting to jump at the opportunity to invest with a higher interest rate. Keep in mind that peer-to-peer lending is risky, and you may lose money.
Before you do any investing, analyze your budget and see how much free capital you have to put into a P2P platform.
Lessen your exposure by starting small to see how you do. If you like the process, increase your investments over time if you’re in a position to do so.
Understand the borrower
Before you issue any money on a lending site, do your research and find out as much as you can about the borrower. Look into how they intend to spend the money so that you understand where your cash is going and how the investment may fare.
You should also look at the borrower’s track record and see if they have a history of making good on other payments.
That’s not to say you should entirely write someone off for past failures. A borrower may be an entrepreneur who takes a lot of risks. Some pan out while others fail. Being unable to pay back a loan isn’t always a question of character.
Sometimes, it’s just a matter of bad luck or a failed opportunity. That being the case, it’s important to keep an open mind when lending.
Ultimately, investing in peer-to-peer lending is always a gamble. But by doing your research, you can make informed decisions.
Have an exit plan
Check the conditions of your loan and know your options before getting involved. Some lending platforms enable withdrawals and early exits, while others require lenders to wait out the duration of a loan.
See if a lending platform offers a secondary market where you can sell your loan if you need to make a quick exit. Otherwise, you may be in it for the long haul. That might not be the end of the world if you can afford to float the cash awhile.
Is peer-to-peer lending right for you?
Peer-to-peer lending isn’t for everyone. As such, it’s best to proceed with caution before diving into this market.
With that in mind, here are some signs that peer-to-peer lending may be a good fit.
You can take on risk
Make sure your portfolio is in a position to take on risk. Have a financial advisor analyze your portfolio from top to bottom to understand your unique financial circumstances.
Your advisor may inform you that you have too much invested in assets like high-growth stocks, mutual funds, and cryptocurrency and that expanding into peer-to-peer lending could do more harm than good to your portfolio.
At the same time, your advisor may advise you to invest in peer-to-peer lending if your portfolio is too conservative and you’re not getting the types of gains you need to get ahead in the market.
Whatever you do, hold off before going into peer-to-peer investing until you understand how your potential investment aligns with your overall portfolio.
You don’t get rattled by bad investments
Investing in peer-to-peer lending isn’t for the faint of heart. If you spend enough time in the stock market, you’re going to have ups and downs. You’ll win some investments and lose on others.
Make sure you have the temperament to deal with peer-to-peer lending and can keep a cool head when things don’t go your way.
Try investing in more traditional assets first to gain experience managing volatility and making sound decisions instead of emotional ones.
You’re comfortable lending to strangers
Another thing that takes some getting used to is lending to strangers. You’ll typically have limited visibility into how the person is actively using your money and whether it’s going towards its intended investment.
To some extent this doesn’t matter. You shouldn’t care whether your money is being used appropriately as long as the payments are rolling back your way with interest.
If you’re the type of person who may feel a sense of obligation to see how your money is being spent, peer-to-peer lending may not be for you. Most lenders don’t get this type of control using online platforms.
The pros and cons of peer-to-peer lending
- High interest rates
- Quick and sometimes instant processing
- Diverse market
- Flexible loan amounts
- You may not get your money back
- Lack of visibility
- Limited regulation
- High risk
- Not secured by the FDIC
- Platform fees
Frequently asked questions
Do small businesses use peer-to-peer lending?
Peer-to-peer lending is becoming increasingly popular among small business owners who need quick funding to run their organizations. Peer-to-peer funding is for anything from buying supplies to paying rent or making payroll.
Lenders should consider working with small business owners who need funding rather than individuals, as they are typically more accountable and reliably make their payments.
Is peer-to-peer lending risky?
Peer-to-peer lending is one of the riskiest types of investments.
This is largely because there’s no guarantee your borrower will pay you back. You could invest a sum of money and never see a return. In fact, you could lose the entire investment.
You need to be very careful when exploring peer-to-peer lending. Make sure you won’t go broke if the person you lend money to is unable to make good on their loan.
Does Lending Club still let you invest in notes?
Lending Club no longer offers peer-to-peer lending through its Notes service. However, the company is currently planning additional investments following the acquisition of Radius Bank.
For more information, check out Lending Club’s website.
How much do you need in your bank account to do peer-to-peer lending?
The general rule is to have a healthy amount of money tucked away in secure savings accounts and no credit card debt before you start investing.
That said, you can invest in peer-to-peer lending with as little as $25. Of course, if you have more disposable income, you can issue larger loans.
What do borrowers use peer-to-peer lending for?
Borrowers tend to have a variety of motivations for using peer-to-peer lending.
Some use it for making monthly payments or consolidating credit cards or student loans, while others use it to launch businesses or make capital improvements on their rental properties.
At the end of the day, different types of lending platforms provide niche funding for specific investments. Do your due diligence to make sure you know what you’re getting into before signing on the dotted line.
Does peer-to-peer lending require a loan application?
Requests and approvals tend to vary from platform to platform.
However, almost all platforms require the borrower to register and provide personal information when issuing a loan request. In most cases, the application process is fast and efficient.
What is debt consolidation?
Debt consolidation involves using a loan to pay off multiple debts with varying interest rates. By taking out a loan, you can pay off each debt and instead make one monthly payment to a third-party lender with a lower interest rate.
What is a prepayment penalty?
Individual and small business loans come with specific loan terms. Issuers may issue loans for three-year or five-year periods.
When a loan has a prepayment penalty, the borrower will be penalized financially for paying back the loan in full before the end of the term. The penalty is determined by the terms outlined in the loan agreement.
Can someone get a peer-to-peer loan with a bad credit score?
Peer-to-peer loans are excellent for people with bad credit reports, who can’t otherwise secure them from traditional financial service providers or traditional lenders. Eligibility is based primarily on need instead of past performance.
That said, creditworthiness is still very important to consider when issuing someone a peer-to-peer loan.
Be extra careful about issuing unsecured personal loans to someone with a low credit score, and make sure the interest rate you get back is high enough to justify taking on the extra risk.
What is liquidity?
Liquidity refers to an investment’s accessibility or ability to be turned into cash.
An investment tied up in a certificate of deposit (CD) has low liquidity because you typically can’t access the money before the term is up without paying a penalty. On the other hand, a checking account has very high liquidity because there’s no barrier preventing you from accessing your money at any time.
The key is to build a portfolio with illiquid, long-term investments and liquid short-term accounts you can access on an as-needed basis.
The bottom line
Peer-to-peer platforms enable peer lenders to issue personal loans to borrowers regardless of their credit history or personal need.
A P2P lending platform is one of the riskier financial products to invest in, but it gives you the chance to issue loans at a high interest rate. At the same time, you could truly make a difference in someone’s life by betting on them when traditional financial institutions shoot them down.
All this being the case, peer-to-peer lending is something investors should at least know about and consider in their personal finance journey.