If you’re tired of fixed rate investments that pay next to nothing, you may find salvation in the growing peer-to-peer lending (P2P) market. This type of investment comes with more risks than with those you’ll find elsewhere, but there’s potential for greater earnings as well. Before taking the plunge, however, it’s important to understand how it works and the risks you’ll confront.
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How P2P Investing Works
P2P platforms are called “peer to peer” because they bring regular people – peers – together to participate in two sides of the same transaction. While borrowers turn to P2P lending in order to apply for a loan, investors show up in order to secure higher than average returns on their investment capital.
Since there is generally no middle man involved in these transactions, fees are usually lower. Meanwhile, interest rates available to borrowers are often lower than rates offered by traditional banks as well. And to an even more extreme degree, the interest rates P2P investors earn on their money can be considerably higher than what they might earn by putting their money in a certificate of deposit or money market account.
For example, Lending Club’s advertised rates range from 6.95% all the way up to 35.89%. No matter who you bank with, this is dramatically higher than what you can get even on a long-term certificate of deposit.
This isn’t to say that banks are totally absent from the process. A P2P platform may use a bank as the servicing agent to administer each loan. But since the role of each bank is limited, the fees paid out to them only average around 1 percent per year.
If you choose to invest in a peer-to-peer lending platform, you will most likely invest in a series of “notes.” These notes represent small slivers of various loans, with some denominations as small as $25. Using this method, P2P lending sites allow you to spread a relatively small investment across many different loans. For example, a $10,000 investment can be spread across 400 notes of $25 each.
In order to become an investor on a P2P platform, you need to meet certain criteria. On some sites, you need to be an accredited investor, which means you must meet certain stiff income or net worth requirements. On others, you must meet your state requirements, which typically include earning a minimum income of $70,000 per year and/or having a minimum net worth of $250,000.
Popular P2P Investing Platforms
There are a growing number of P2P platforms that welcome investors. Three of the most popular include Lending Club, Prosper, and SoFi. All three are multibillion-dollar lending platforms, although each offers slightly different terms and requirements for investors.
In addition, some lenders in the P2P realm focus mainly on certain types of loans. For example, Lending Club and Prosper will make loans for just about any purpose, while SoFi favors student loan refinances and consolidations (although it offers personal loans as well). Other P2P lenders may focus on small business loans or almost any other niche you can imagine.
On most P2P platforms, loans are funded by both private individuals and institutional investors. Some P2P platforms will even allow you to a hold your investments in an individual retirement account (IRA). Meanwhile, it is possible to get double-digit returns on your money by investing in lower grade notes, which naturally carry a higher risk.
There is one very significant point to note before investing on any P2P platform – the loans that you are investing in are self-amortizing. That means that the value of your investment will gradually move towards zero as each payment is made.
Unlike CDs and bonds where you put up a fixed amount of money and collect your interest over the term of the security, P2P loans change in value over time. With P2P investments, you are investing in loans that are comprised of both principal and interest. In other words, you’ll earn most of your interest upfront, while receiving most of the principal back towards the end of the loan’s term.
For that reason, you must continually reinvest the payments that you receive into new notes. That will ensure that your money is fully invested, which will help you earn the rate of interest you expect.
Higher Rates of Return on Fixed Rate Investments
As noted earlier, you can easily earn double-digit interest rate returns on P2P investments – which is clearly the main attraction of P2P lending platforms. Generally, this is accomplished by including higher risk loans in your portfolio.
For example, Prosper grades it’s loans from “AA” (highest) to “HR” (lowest, or “higher risk”). AA loans pay an average of 5.48%, while HR loans pay an average of 10.78%. By investing primarily in HR loans, you can earn double-digit returns on your money.
…But With Higher Risk
There are four critical factors you need to understand when investing through P2P sites:
- P2P borrows can default, in which case you can lose money.
- The higher the rate of return on a loan, the greater the likelihood of default.
- There is no FDIC insurance coverage to protect your investment as would be the case if you held your money in a bank.
- The P2P site may require you to cover certain collection costs in the event that a loan goes into default.
Another factor to consider is that P2P platforms don’t underwrite loans according to strict bank standards. For example, SoFi will make a loan to a recent college graduate on the basis of a promise of employment, rather than an actual job.
If you are going to favor high risk/high return investments, you need to be aware of exactly what you are investing in. It is possible that because of loan default rates, your the higher returns could be cancelled out. It is also worth considering that P2P lending is a relatively recent phenomenon, and how the loans will perform in a recession is not entirely certain.
So Is P2P Investing a Good Idea?
Investing through a P2P platform can work well if you understand the risks you are taking. With that being said, the approach is to use P2P investments to supplement the fixed income portion of your investment portfolio.
Let’s say you are holding 30% of your portfolio in interest-bearing investments of varying maturities and earning around 3%. By investing 20% of your fixed income allocation in P2P loans that earn an average of 6%, you can increase the overall rate of return on your fixed income allocation from 3% to 3.6%.
Meanwhile, you should probably steer clear of investing all of your fixed income allocation into P2P loans. By doing so, you may be taking on an excessive level of risk. Lending Club recognizes this fact, and recommends that you limit your investment in their notes to not more than 10% of your net worth. That’s good advice.
Getting the Most Out of P2P Investing – For the Lowest Risk
Some strategies can help you reduce the risks involved in peer-to-peer investing. Here are some to consider:
- Diversify your holdings across many different notes, so that a default on any one of them will not be a disaster
- Favor loans with higher credit scores
- Favor loans with lower debt-to-income (DTI) ratios
- Favor debt consolidation loans over purchase money loans (loans that lower a borrower’s monthly payment are less risky than those that increase it)
- Favor loans where the borrower has greater employment stability
If you’re aware of the risks involved in P2P investing – and you know how to at least partially mitigate them – then P2P investments can be a welcome addition to your portfolio.
Do you invest in P2P loans? What has your experience been?