What is Peer to Peer Lending?

Peer-to-peer lending offers military personnel and Veterans an alternative to traditional bank loans, providing an opportunity to borrow money directly from individual investors with potentially lower interest rates and flexible terms.
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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 100% 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 9-12%. 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.

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  1. JJ says

    I guess I’m late on this topic. I’ve made a donations through Kiva and have been hearing in P2P, but never took the plunge. Decided to try it out, but many of the sites you mention are closed to lenders, except for Lending Club.

    They say the average return is 9% after losses and fees. is this your experience? I’m going to try it out with $1K but I’d like to hear from other lenders before putting in more.

  2. Ryan says

    Brian: I don’t know if they companies have made a sample P2P financing agreement public or not, but it couldn’t hurt to contact them regarding the issue. I have personally funded loans through Prosper and Lending Club and I didn’t have any problems with the agreement for the lender. Just keep in mind when lending that the loans are not guaranteed.

  3. Brian says

    I am investigating the idea of offering peer to peer financing. Does anyone know where I could review a sample peer to peer financing agreement? I want to make sure I have everything in writing.

    Thank you.

  4. Adfecto says

    @ Ryan

    About defaults, I have read in other sources that the collection agencies used by Prosper have a poor track record of recovering funds from bum borrowers. These companies also take a fee for their service. When there is a default you stand a very good chance to loose most of your money. Even AA loans loose 1.75% of their return to defaults (A – 4.76%, B – 7.45%, C – 10.78%, D – 10.58%, and E – 16.52%). With these kinds of defaults you are fighting uphill for every dollar you get. In order to diversify enough to get these average rates and be sure not to just loose 100% of your investment, you should fund about 100 loans for every one you think will go bad.

    To invest in AA you should fund 175 loans at $50 each ($8750) to smooth out returns to get close to the average. Obviously this goes up dramatically as you go down in credit worthiness. When you get to D credit grade you should fund 1058 loans at $50 ($52,900) to spread your risk correctly to loose ‘only’ 10.58% of your APR. With small amounts your APY will differ greatly from your coupon because the returned capital can not be easily reinvested if it is small amounts.

    If you loan out $50 it will take forever to get back enough profit and principle to make another loan so you money sits in Prosper earning no return. You loan out $50 for 3 years to an A borrower at an 11% rate. After fees and assuming you don’t have a default (with is a 1 in 20 chance) you will find that your annualized return is only about 4.5%. This is because of fees and because an average half of your capital was actually sitting on the sidelines. If you have a massive amount you could fund a new loan (or a few) each month from your returned capital so your yield would actually approach the coupon (which is the amount of interest most lenders THINK they are getting paid) value.

    Now to address performance. When it is all said and done 8.14% from an AA borrower or 6.95% from an A borrower (net fees and defaults) is not enough return to justify the risk. There are corporate bonds from companies like Ford, JP Morgan, Royal Bank of Scotland, and MGM Mirage that pay better than 6.95%% and they are backed by real assets. As you move lower down the credit scale it gets even worse. There is nothing securing a Prosper loan beyond a credit score and harassing phone calls from a debt collector. You see my point?

    Anyway, this turned into a phone blog-post as comment. I’m probably going to post it over at my blog now. I haven’t proof read and things aren’t perfectly explained but I hope you now have a picture of what a mediocre (at best) investment peer to peer currently represents.

  5. Ryan says

    Adfecto, The default rates are terrible if you make sub-prime loans; loans to highly rated borrowers have extremely low defaults. The impetus is on the lender to do his or her research.

    I agree, the companies are young, but the business plan is solid. If the companies fold, there are credit agencies that will take over the loans. If they are bought out, I imagine the loans would stay in place as they are. They are legal documents, and so far as I know, they are not subject to change at someone’s whim.

  6. Adfecto says

    The default rate is terrible. The fees are high. The companies are young and unstable; what happens to the loans if Prosper.com goes under or is bought out? I will wait on the sidelines until there is a proven track record and the returns justify the risks (neither are true right now).

  7. Mrs. Micah says

    Like any investment, I think one of the best ways to be safe is to diversify your loans. $50 max per loan, for instance, won’t bankrupt you if it’s not fully repaid. And of course there’s such a variety of risks, just like in stocks.

  8. lulugal11 says

    I love the idea of person to person lending. I am both a lender on Prosper and a borrower on Lending Club.

    I have a good credit history and I wanted to get a loan to pay off credit cards that have high interest rates. My banks and credit unions did not offer me a low enough rate to make it attractive..but Lending Club did.

    My payments of my loan are current and the income from the small loans I made are also current.

    This is a great idea and I encourage people to try it out. At the very least just use the bonus money they give you to fund a loan and then you can do more later.

  9. Jose says

    I do believe in person to person lending.
    I have a small $5000 portfolio in prosper.
    Hopefully it will keep doing well – no defaults yet.

  10. Ryan says

    Hi fathersez,

    Prosper first lines up the lenders for the loan, which guarantees the loan will be backed by enough people. Once they have enough people to fund the loan, Prosper makes the loan with their money, then sells small portions of the loan to the lenders who had previously agreed to fund the loan. Prosper handles the loan payments and distributions from there. In this case, the people buying the loans are almost like the bank; Prosper just acts as the middleman between the lender and borrower. But you are correct about the lack of overhead causing the rates and associated costs to be lower. It is an interesting concept, and one that I will write about in the future as I begin my investing journey with peer to peer lending.

  11. fathersez says

    This is a good outline of this P2P thing. We don’t have such a thing in our country. It is a very interesting concept.

    So Prosper makes the loans first then sells down the loans?

    Do they also handle the collections and pay the “final lenders”?

    Banks take money from depositors and lend them out to borrowers. Can Prosper be compared to banks, except that it may have a far lower overhead and hence their cut need to be smaller?

    I must find out more about this.

    Thanks, Ryan.

  12. CiaranFromChance says

    Hey Ryan,

    Well written and informative. It seems like this is catching on as I’m seeing more and more of this on different sites. It’s an interesting concept and i look forward to your future updates.

    Who knows, I may have found another non correlated investment to recommend clients use, to further diversify their portfolios. Not just yet but maybe…

  13. Ricardo Bueno says

    I read an article in the newspaper back in December that was talking about the continuing Credit Crisis and how it’s impacting the housing market. What I found particularly interesting about the article is that it hi-lighted Peer-to-Peer Lending as the new “go-to” financing method for homeowners looking for some cash to get by. I’m surprised at the yearly dollar revenues that’s made in this.

    If I find the article I’ll reference the figures in the comments.

  14. Ryan says

    Laura, I would first make sure you have a well rounded portfolio and a basic emergency fund in place before doing this kind of investment. Then, I would probably only do a small portion of your portfilio with it, at least until you understand it better. It is definitely not for everyone, but I think it is a viable option for many.

  15. Laura says

    I enjoy this well written primer. I’m working on paying off my car loan before considering going into this area of investment.

  16. Pinyo says

    This is a very good informative post that does an excellent job of introducing the concept of peer-to-peer lending. Thank you.

  17. Ryan says

    Living off Dividends, I recently signed up to lend on Prosper and just funded my account. I plan on writing about it in the coming days and weeks. Hopefully I will be able to share a few tips that I have learned along the way, and hopefully I will end up making more money than if I placed my money into a CD. Yes, the CD is guaranteed, but the P2P loans offer a greater chance for reward with some added risk.

    One 2 One Lending, You make some very good points. If you are lending money to an individual, you want to always ensure that you do so with a binding legal agreement so you are covered from a legal standpoint if they do not pay. When you lend through a company such as Prosper or Lending Club, they make everything legal and the “lender” is actually buying a piece of the loan that was already made. Essentially the lenders buy a portion of the debt.

    Thanks for the comments.

  18. AEL says

    It’s never easy to say no to a customer. But lending a financial hand can leave you out of money and out of sorts with your customers.
    According to One 2 One Lending, a company that helps formalize loans between individuals, about 14% of private loans end up in default, compared with just 1% or so for bank loans.
    To protect you financially, make sure you don’t fall for the top four costliest mistakes individuals make when lending money to customers:
    • Not being suspicious enough. When someone comes to you for a loan, your first thought should be: Why? That is, why do they need the money, and why are they asking you for help?
    You also need to wonder hard why they haven’t been able to get a loan from a more conventional source. Point is: There are plenty of folks in the business of lending money. If your customer can’t get money from someone in the lending business, that’s worth two or three red lights going off in your head.
    • Lending what you can’t afford to lose. Never lend money that you truly need. The best litmus test before you say yes is to ask yourself if you would be comfortable giving the money away.
    • Skipping the formalities. Handshakes are not good enough for sealing a loan agreement. Put everything in writing. In fact, it’s a good way to size up the credibility of the person who needs your money: They should tell you right off the bat that they want to sign a formal loan document with you that spells out the terms of the deal. Once you have it filled out, all parties should sign it in front of a notary; it’s just a nice bit of formality to have in your pocket in the event anything goes wrong. In the document you want to spell out the specifics: What interest rate you will receive, when the payments are due, how much is due with each payment and what penalty will be paid for a late payment.

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