What is Peer to Peer Lending?

Peer to Peer Lending, or P2P lending, is lending that takes place between individuals and bypasses the traditional role of borrowing money from a bank or lending money to a bank in the form of CDs or deposits. Why do this? Simple – because there is a lot of money involved and many people want in on the action. Peer-to-peer lending allows “regular Joe’s” the opportunity to play the role of the banker and assume the same risks – and rewards.

How Does Peer-to-Peer Lending Work?

Peer-to-peer lending involves a borrower submitting a loan application and lenders bidding to fund the loan. In the case of Prosper, a borrower first applies for a loan. Then their credit risk and other factors are considered and posted for lenders to search and bid on the loans. When there are enough lenders to fund the loan, Prosper loans the borrower the money, then sells portions of the loan to the lenders. Lenders are buying a piece of the loan, not making the loan. Since you can buy into a loan for as low as $50, it is easy to mitigate risk by diversifying over several loans. The process may vary slightly between different P2P lending companies, but the principle is similar.

Who Benefits from P2P Lending?

Everyone benefits with peer to peer lending, as long as everything goes as advertised. Borrowers benefit because they can get a loan, often at a lower rate than they would have been able to get at a bank. Loans can often be made at better rates to borrowers because there are fewer overhead costs associated with the loan. Lenders benefit because they often receive higher returns on their money than had they placed their funds into a CD. Returns of 9-12% are not uncommon. However, your exact results may vary. Peer-to-peer lending companies such as Prosper or Lending Club benefit because they take a small percentage of the originating loan cost.

Is Peer-to-Peer Lending Safe?

The P2P lending process is safe, but as with making any loan, peer-to-peer lending involves a certain amount of risk. The best way to mitigate this risk is to fully research the credit rates assigned by the P2P companies and diversify your funds across several loans. Since you can bid with as little as $50, it is very easy to diversify your money. If you go with a reputable company, such as Prosper or Lending Club, you are assuming the same risk a bank would, just on a smaller scale.

The Person-to-Person Lending Process

The lending process is similar to a financial institution providing a personal loan to an individual. The loan is legal and is reported to the major credit bureaus, and there are collection agencies in the event of a default. Borrower ID Verification: The borrowers provide all their financial information, including SSN, date of birth, address, telephone number, and bank account, for verification. They also provide income level and profession. This info is used to verify the borrower’s ID against anti-fraud and credit databases. Prosper does a full credit check to determine credit scores. On top of that, Prosper has a  guarantee against identity theft to protect borrowers and lenders. Defaults: If a borrower defaults on a loan, it is reported to the major credit agencies, and established collection agencies go after the money for the lenders. A loan from Prosper or Lending Club is legal, just as if it originated from a brick-and-mortar bank. One small difference – Lenders aren’t actually lenders. The loan is made by Prosper with their operating funds when enough “lenders” have agreed to fund the loan. Once Prosper makes the loan, the “lenders” buy pieces of the loan. I put the word lenders in parenthesis because they are not actually lending money. They are buying a piece of the loan that Prosper made. At this point, you become a lien holder. The term lender is used because it is easier to identify with.

The P2P Loan Process is Safe

The loan you are purchasing is no different than a bank underwriting an unsecured loan to another person. Security and verification measures are put in place, the loans are reported to and tracked by the major credit agencies. In the event of a default, there are collections agencies to help recoup your investment. While the process is safe, there is risk involved. These loans are unsecured and not guaranteed. They have the same risk that a regular financial institution takes when they make an unsecured loan to an individual. However, the interest rates charged by the peer-to-peer lending companies are designed to offset the risk.

Peer-to-Peer Loans Are Not Guaranteed

The rate of return for P2P loans is not 100% guaranteed. However, the P2P lending process is safe in that it has a defined lending process, is a legal loan, and is reported to credit agencies.

The P2P Lending Process

The process works similarly to a financial institution making an unsecured loan to an individual. The borrower’s ID and financial history are verified, their credit score and history are investigated, and their debt-to-income ratio is determined. The lenders assign a base interest rate for the loan from this information. The risk is similar to what a bank assumes when they underwrite an unsecured loan to an individual. Prosper agrees to fund the loan on the condition that enough “lenders” agree to buy the loan from Prosper when it is funded. So actually, the “lenders,” people like you and me, are buying a piece of a legal loan made by a financial institution.

Lender Protection

Once the loan is made, the borrower pays the funds to the P2P lender, which then doles out the payments to the lenders. If a payment is missed, late fees are assessed to the borrower. If the loan defaults, it goes against the borrower’s credit report, and there are collections agencies to collect the money. Skipping out on a P2P loan has the same consequences as skipping out on a personal loan made by a financial institution. So no, the loans are not 100% guaranteed, just like an unsecured personal loan from a financial institution to an individual is not guaranteed. But it works the same way and has the same consequences for the borrower.

Why Lend Through P2P Lenders if the Loan Isn’t Guaranteed?

The P2P Lending process allows individuals to “be the bank” and have the opportunity to earn more money than they could otherwise earn in a savings account or CD. Prosper and Lending Club make their money by taking a small cut of the final loan value and other service fees. When it works properly, everyone is happy – borrowers get a better rate on their loans, lenders get better interest rates on their investments, and the P2P company takes a small cut from each loan.

There is a Risk Involved

As with any investment, you should do your research before investing. Some P2P borrowers are people with very high credit scores and low credit risk. However, that does not mean the loan is a guarantee. Other borrowers have very poor credit scores or histories, and the interest rates are usually higher. Lenders assume the same risks that banks assume when they make an unsecured loan to an individual.

Protect Your Investment

The best way to protect your investment is to make informed decisions on which loans to fund and to diversify your loans by spreading your investments among several borrowers. Loans can be made through Prosper for as little as $50 and through Lending Club for as little as $25. This makes it much easier for lenders to loan small amounts to a.) fund loans with a small initial investment and b.) diversify their loans to decrease the risk of any large investment defaulting. With P2P lending, diversification is paramount.

Which Companies Offer Peer-to-Peer Lending?

There are quite a few companies around the globe that offer P2P lending. The most prominent peer-to-peer lenders in the US include:

• Lending Club
• Prosper
• Funding Circle
• Kiva (Kiva offers loans to people in 3rd world countries; lenders only receive their principal back but do not earn interest. This is seen mostly as doing something good with your money and giving people an opportunity they may not have otherwise had).

Why Participate in Peer to Peer Lending?

The reasons differ for borrowers and lenders. Borrowing through a peer-to-peer company often allows borrowers to get a loan at a lower rate than through a bank or get a loan when a bank would not give them one. For lenders, peer-to-peer lending allows you to “be the bank.” When you make loans or buy a portion of a preexisting loan, you are offering someone money and getting paid for taking on the risk of doing so. Lenders also have the chance to diversify their money over many loans, creating multiple income streams. As the loans get repaid, the lender can lend the money in new loans or withdraw the money.

Do You Need a Lot of Money to Get Started?

No. In most cases, you can start lending for as little as $50, which allows you to make small investments and diversify your loans across several borrowers and risk classes. This helps to lower the risk involved in any one loan not being repaid and destroying your entire investment.

How Much Money Can You Make with P2P Lending?

This varies depending on the loans you purchase, the risk involved, and many other factors. Some P2P lending companies offer plans that are already diversified and offer a “target” return. There is no guarantee the return will meet the target, but it is designed to get you there. Prosper is currently advertising average lender returns of around 5.5%. Of course, your outcome may differ depending on your portfolio and what happens with each loan. Just remember – there is no guarantee with these loans. But that is precisely why they offer better returns than a guaranteed investment such as a CD. Lenders are rewarded for taking risks.

Should I Invest in Peer-to-Peer Lending?

Aha! I can’t answer that one for you! I can tell you, though, that just like everything else, you need to consider your total asset allocation and your ability to deal with risk.

I have invested in Person to Person Loans

I have invested in several loans with Prosper and Lending Club. I only invested with funds that I could afford to put at risk. Just like any other investment, you need to research to determine the level of risk you are willing to assume and the percentage of your portfolio you are willing to invest. The best way I have found to lend is to research which borrowers might represent a low-risk loan – generally someone with a high credit score and a low debt-to-income ratio. While the loan isn’t guaranteed, the returns can be better than a CD or high-interest bank account.