One of the more popular ways to invest these day is through peer-to-peer lending.
Many borrowers are avoiding traditional bank loans and turning to peer-to-peer lending for their financial needs. Likewise, many investors are using peer-to-peer lending as a part of a diverse investment portfolio.
But how does it work? And is it worth the risks?
What is peer-to-peer lending?
Peer-to-peer lending, in a nutshell, is when borrowers take out loans from companies that pair potential borrowers with individual investors that are willing to lend them their own money.
The individual investors decide after reading a profile whether or not they want to take the risk of loaning money to the potential borrower. Potential lender investors can agree to loan part – or all – of the money the borrower is asking for.
Most peer-to-peer (also called P2P) loans are funded by several different investors, and as the loan payment is made each month, a portion of the payment goes back to each of the different investors involved with the loan.
The ability to diversify when investing in P2P lending attracts all types of investors, from the seasoned investor to those just beginning in investing.
Which companies facilitate peer-to-peer loans?
- Offers interest rates from 5.99% to 35.89%, depending on credit history and other factors.
- Charges origination fee of between 1% and 6%. The 1% fee is available to top-tier borrowers only. All others will pay between 5% and 6%.
- Charges other fees as well, such as unsuccessful payment fees, late fees and check processing fees.
- Loans up to $40,000.
- Loan term is based on loan amount. Terms of 36 or 60 months are available.
- Offers interest rates from 5.99% to 36.00%, depending on credit history and other factors.
- Charges closing fee of between 0.50% and 4.95%. The half-percent closing fee is available to top-tier borrowers only.
- Charges 1% annual loan servicing fee as well as late fees and failed payment fees.
- Loans up to $35,000.
- Loan terms of 36 or 60 months.
As you can see, from a borrower’s perspective the two biggest P2P lending companies are pretty similar, although it seems as if Prosper might have slightly stricter lending standards, which can be a bonus for investors.
What’s the minimum amount of money needed to get started investing in P2P lending?
We’re going to talk only about investing with Prosper and Lending Club simply because they are the two biggest peer-to-peer lending companies. At both Prosper and Lending Club, the minimum investment to get started in P2P lending is just $25, and you are required to invest a minimum of $25 into each loan you want in your investment portfolio. Both companies charge a one percent annual fee to investors.
Both Lending Club and Prosper allow you to invest via a traditional taxable investment account or via an IRA tax-deferred investment account.
The Securities and Exchange Commission (SEC) also has some minimum investor standards for P2P lending. They include in part:
- A minimum $70,000 gross annual income (in most states – California’s minimum for gross annual income and net worth minimum is $85,000), as well as a net worth minimum of $70,000.
- You must live in an approved state. Currently all states are approved for P2P investing except Arizona, New Mexico, North Carolina, Ohio and Pennsylvania.
- Net worth exception: If your net worth is at least $250,000, there is no minimum annual income requirement.
The individual P2P lending sites will have all of the qualification information you need to get started as an investor. Starting investing in P2P companies is as simple as depositing your opening balance and beginning to assess potential borrowers.
How is money made from P2P investing?
As the borrower, you and the other lending parties involved in the loan receive principal and interest portions back into your P2P lending account. The profits are then available for you to re-invest or to transfer out of your P2P lending account.
As with any type of investment, the potential for loss is a possibility if one or more of the borrowers you lend money to can’t or won’t pay back their loan.
What are the average P2P lending returns?
This chart, courtesy of Investor Junkie, shares six years of annual returns for both Lending Club and Prosper.
Prosper has Lending Club beat ever year as far as annual returns are concerned, although in 2013 and 2014 Lending Club was closing the gap.
Should you invest in peer-to-peer lending?
That’s a question only you can answer. Looking at the history, the returns look good, but remember that this report is based on the average of all of their loans. As an investor, you choose which loans you do or don’t invest in, and your return results can – and probably will – be different based on which loans you choose to help fund.
The great thing about peer-to-peer lending as an investment is that it allows you to start investing with a small amount of cash. If you’re considering trying P2P lending but are unsure about taking the risk, you might consider starting by only investing what you are comfortable losing if all of your loan choices happen to default.
One other important thing to consider is diversification. Most people that use P2P sites as an investment strategy recommend starting with a minimum of $1,000 and investing in many different loan opportunities — and usually investing in loans with people that have good credit.
That money should be money you are willing to lose, even though that is certainly not the intention. P2P lending carries greater risk than investing diversely across the stock market. However, if you are careful about how you invest, P2P investing can provide solid returns that are really hard to beat.