The practice of lending and borrowing dates back to the prehistoric times, or Mesopotamia, to be more specific. Ever since then, it has taken many forms and has been developed through various types of institutions, but at its core, it has remained the same. There is someone who needs a large amount of money on one end, and someone who has a surplus of money and wants to invest it on the other. Nevertheless, even though the essence of lending remains unchanged, there have been many changes regarding numerous other aspects.
One of the most recent innovations in this field is P2P lending (a.k.a. P2P investing), which attracts more and more people across the world, both lenders and borrowers. And indeed, this method has proved to be a great way to circumvent the traditional banking system, opening new doors and solutions to both ends of the spectrum. If you are wondering what P2P investing is and whether you should start investing in P2P loans, read on.
- What is P2P lending?
- How does P2P investing work?
- How do you earn through P2P investments?
- Types of P2P lending / P2P investing
- How to become a pro at P2P investing?
- Pros and cons of P2P investing
What is P2P lending?
P2P (peer to peer) lending is the practice of lending and borrowing which is not implemented through banks. Instead, it mostly consists of online lending realized through various P2P platforms. These are websites that connect borrowers and private loan lenders to create a sustainable lending community.
Unlike traditional banks, which usually offer low annual interest rates to investors and high interest rates to borrowers, lending platforms offer much better conditions to everyone involved. This is a direct consequence of there not being a middleman (i.e. the bank). Due to the fact that P2P lending requires less employees and no physical branches, this business produces only a fraction of the cost that the traditional banking system does.
How does P2P investing work?
As we have already mentioned, P2P platforms bring together lenders and borrowers, thus creating an online lending market. Some of the most reliable platforms are Upstart, Funding Circle, SoFi, Lending Club, Peerform, Mintos, Bondora, etc. On these websites, both lenders and borrowers create profiles in order to search for the best opportunities. Borrowers state the amount of money they need, their credit score, debt-to-income ratio, etc. They usually can apply for business loans, personal loans or student loans.
On the other hand, after reading a borrower’s profile, a lender decides if they want to lend them a part of their money or all of it. In most cases, there are more lenders who invest in one loan, which means that when the borrower returns the money, a part of the installment is returned to each of the lenders according to their share in the loan. For example, if a borrower needs $5,000, you can lend them $100. When the borrower starts paying back the money, a part of your $100 will be returned to you each month, plus the interest rate. Sounds good, right?
How do you earn through P2P investments?
First of all, let us mention that there is definitely some risk involved in peer to peer loans. However, it is important to note that you can absolutely minimize the risk if you gain knowledge on this topic. And with practice, you will only get better and see how your return on investment grows.
Also, some lending platforms offer a buy-back guarantee option. In case a borrower defaults, the platform buys back the loan and takes care of the legal procedures. That way, the lender faces much lower risk. On average, default rates in peer to peer lending industry vary from 1.5% to 10% for high-risk borrowers.
It is important to note that the interest rates in P2P lending usually range anywhere from 5% to 36%. In addition, P2P platforms approve loans to many people who would not be eligible for a bank loan because of their bad credit score. Finally, due to the different business model and the lower maintenance expenses that these platforms have when compared to banks, it is obvious that the average return has to be higher than if you invested your money in the bank.
In fact, often you can get as much as 10% return on investment, if all works out. But if you want to be more “realistic”, you can expect to get around 7% return. After your investment is returned, you will be able to reinvest the money or withdraw it from your P2P lending account.
But how does all this work for P2P platforms? Actually, it is rather simple. They charge fees to both borrowers and investors. For borrowers, this usually includes an upfront fee plus a small margin, which together often amount to 3-5%. When it comes to lenders, they are charged a fee which is already deducted from the interest rate they receive.
Types of P2P lending / P2P investing
There are four principal types of peer to peer investing: consumer loans, business loans, student loans and real estate loans. Whether you are an unaccredited or accredited investor, most of these P2P lending loan types can give you an excellent opportunity to make a profit.
This type of P2P loans is definitely the most popular and the fastest-growing. In general, these are smaller loans which people use to pay for medical expenses, credit card consolidation, etc. Most people who take out such a loan have good credit scores and are very likely to pay the money back on time. Some of the best platforms that offer these loans are Lending Club, Prosper and Zopa.
Small business loans
Almost everyone who wants to start or further invest in their business needs a loan at some point. Recently, many business owners have opted for P2P loans, which they usually can get within a week. If you would like to invest in these P2P loans, you want to search platforms like Funding Circle and OnDeck.
Nowadays, a person’s level of education largely decides which road they are going to take. That is the reason why many young people are ready and willing to get into debt in order to pay for college. Students have two options ‒ to get a consolidation loan after graduation or a traditional student loan while in college.
This is a great chance for investors even though yields are slightly lower for these loans. In addition, if you want to help someone pay for their education, this is the perfect loan for you. CommonBond and SoFi are the two leading platforms that specialize in student loans.
Real estate loans
The real estate loan market has long been dominated by banks and has created a huge amount of debt in the US. For this reason, people are increasingly turning to P2P lending platforms like EstateGuru, Realty Mogul, SoFi and others. These and similar P2P lending websites require much simpler and less time-consuming procedures compared to banks. Apart from mortgages, borrowers apply for bridge loans, construction loans and first trust deeds.
How to become a pro at P2P investing?
If you are a beginner in this industry, you should tread carefully and turn to someone who is experienced. You can also read online content about P2P lending as there are numerous blogs and websites that cover this topic. For all of you who are new to P2P investing or are thinking about venturing into it, we want to share a few success tips which can save you a lot of time, money and effort.
This point is first on the list for a reason. If you want to invest a certain amount of money in P2P lending, make sure you spread it to many different loans. There are different categories of loans, from low risk to high risk. The ones with low risk also have low interest rates and low returns. On the other hand, the risky ones provide higher interest rates and higher returns, but these borrowers are more likely to default.
Therefore, you want to split your money to various borrowers. This will enable you to get a good average return and keep you motivated to invest in the long run. Loan diversification is the most important rule you should keep in mind while investing in P2P loans. Diversification can heavily reduce the risk that is involved in P2P lending.
Choose loans carefully
This point is a direct result of the previous one. If you want to spread your money wisely, you have to look at each loan individually and decide if you want to invest. Another option that you have is auto invest, which is offered by a number of P2P platforms. This feature enables you to automatically invest in many loans according to the filters that you have previously set on your profile. The auto invest feature will automatically diversify your P2P loan portfolio.
Go step by step
Don’t invest all of your money in one day. Rather, go slowly and be picky about the loans you invest in. If you find only one attractive loan a day, then invest only in it. Peer to peer lending is a growing market and if you are patient, you can definitely find lucrative investment opportunities on a regular basis.
Moreover, for the start, make sure you invest a maximum of 1% of your total amount in one loan. This is much wiser than trying to invest as much money as you can right away. Check for new loans every few days and you may discover great new opportunities to invest in P2P loans.
Go for long-term loans
Longer-term loans are rather new in the P2P industry and they are not so frequent yet. However, if you invest in long-term loans, you can expect additional 2-3% in interest rates. It is very simple: platforms know it is riskier to invest in long-term loans. Therefore, they reward you for your willingness to risk by giving you better rates.
Reinvest interest payments
When your invested money starts coming back, you will be tempted to start withdrawing it. Don’t do that. If you want to make a substantial profit with peer loans in the long run, make sure that you always reinvest. This way, you will see your investment multiply at a much faster pace.
Pros and cons of P2P investing
Even though P2P investing is superior to bank loans in many aspects, we still want to list its advantages and disadvantages. This way, you will be able to weigh all aspects carefully and eventually decide whether investing in P2P lending is your cup of tea.
- A lender can be an institution or an individual.
- It is very simple to open an account on online lending platforms.
- There is not as much paperwork as with bank loans.
- You can decide who you want to lend money to and how much you want to invest.
- It is possible to lend small amounts (as little as $25) to one borrower.
- As the borrowers repay the loans, you receive monthly payments of the loan amount plus the interest rate.
- You can split your money into many different loans.
- It is up to you to decide if you want to reinvest or withdraw the money you have earned.
- Average returns are higher than with bank loans.
- P2P lending is rather new and has not yet proven how it can overcome a financial crisis.
- You need to diversify and spread your money to loans with different levels of risk.
- Your money is not as safe as if you invested it in a bank. However, more and more platforms start to guarantee to buy loans back in case of default (though, it’s questionable if this is even possible in case of a financial crisis).
- You need to be patient. P2P lending is not a get-rich-overnight system and it takes time to see tangible results.
There you go. Now you know how P2P lending works and how to be successful at it. You need to be patient, careful and willing to risk a little. And if you persist, you may quickly see that it can largely outperform traditional investing in loans. It is up to you to decide whether you want to invest in this business. Our advice is that you carefully weigh all the pros and cons and start slowly. Then, after some time, when you see results, you can determine if P2P investing was the right choice. What do you think about P2P lending? Please let us know your thoughts in the comments below.