Peer-To-Peer Lending Explained: How Does P2P Lending Work? It’s pretty simple, you lend money to those who wish to borrow, with a view of receiving a great return for doing so.
But first let’s first take a trip down memory lane… Ever since I was a kid I viewed banks as these amazing things that were stuffed full of money. In my imagination, I could see the vault doors opening and gold bars lining the walls and stacks of money as high as the ceiling.
This is probably due to the fact I watched a lot of Duck Tales growing up.
Don’t get me wrong, banks are rolling in it. But nowadays most of the large transactions are done via the internet at incredibly fast speeds by wire transfers. 20 years ago it would be hard to imagine “getting in the on the action”. Never has there been a better time to act like a bank.
Imagine my surprise when someone explained peer to peer lending to me. There I was, young and impressionable and someone I looked up to just explained how I could act like my own bank. He, of course, was talking about peer to peer lending and I was hooked.
In this article we’ll go over: peer to peer lending explained, how does it work, and how you can get involved with peer to peer lending investing.
What is peer lending?
Generally, when you need a loan you go to a bank and they look at your credit score (Don’t know your credit score? – Get your free credit score here), your previous transactions, your net worth, and a lot of other private information. Then they decide to give you money with interest or not.
Peer to peer lending is the exact same thing except you go to a website and ask for the loan and they allow investors to fund the loan and share in the interest payments.
The investors get to act like the bank.
Just as the name suggests, you have peers lending to peers.
Peer to peer lending explained: How does peer to peer lending work?
The three most popular websites for peer lending are Sofi, Prosper and Lending Club.
Check Your Rate at SoFi
When a millennial goes to these sites (you can even refinance your student loans on Sofi) they can ask for a loan for a number of reasons like:
- Home improvements
- Medical bills
- Debt consolidation
The peer to peer lending platform then performs due diligence and looks into your finances. If you pass their requirements they offer the loan to investors.
On the investor side they are able to look at your credit score, how many times you have been late on bills in the past, and your current debt to income ratio amongst other things and fund your loan.
How does funding the loan work?
When a loan becomes available it is given a score. The score is based on how risky the loan is. In other words, how much interest you are likely to get back measured against the amount of risk for a loan not being paid.
The investor then can purchase as little as $25 of your loan all the way up to the entire amount of the loan.
The loan will sit on the platform for up to 14 days while investors bid and buy up parts of the loan.
How do investors make money?
As was discussed earlier, every time a payment is made the investor gets their portion of the interest payment and the principal payment back in their account.
For example, if the loan was for $10,000 at 5% interest over 5 years the monthly payment would be $188.71.
Of that $188.71 nearly $42 would go to interest and the rest would go to principal payments.
If I had 1/10th of the loan I would receive ($42*.1) or $4.20 plus my principal payment.
Let’s be clear, this isn’t a get rich quick scheme. Often times the path to wealth is slow and boring.
But what this does for me is it gives me a way to learn more about money, help others by lending to them, and allow me to act as my own bank.
How does the peer to peer lending platform make money?
Nothing in this world is free.
Both Prosper and LendingClub charge 1% annually for the amount in principal an investor has out in loans.
So the more you invest the more you make (theoretically) and the more fees you pay.
I like fees that are structured at a set rate like this because you can be clear what you will pay as you invest more in the platform.
This is assuming they don’t raise the rate to investors.
Why would a millennial want to invest in peer to peer lending?
- Peer to peer lending has a learning curve. You can view this as a pro and a con. I choose to view this a pro because it keeps people out who are lazy or don’t have time to learn an “alternative” investing strategy. But not you. You are a millennial who is ambitious and curious.
- I love peer to peer lending because it allows me to be active in my investing. When I invest in stocks I give my money to a company and pray they do well and don’t get caught doing something illegal and lose all my money.
- With peer to peer lending, I get to find loans I want to invest in and decide how risky I want my choices to be.
- It feels good to help others who need a loan. If I have $200 laying around at the end of the money I would love to buy a part of a few loans to help other millennials out.
- You can invest in peer to peer loans through an IRA which has tax benefits we won’t cover in this post
Why wouldn’t a millennial want to invest in peer to peer lending?
To this point, I have made peer to peer lending sound like a no-brainer. You might be thinking, what’s the catch? Okay, here we go.
- The loans are unsecured debt. What that means is you don’t have to put up any collateral (like your house) to get these loans. If someone defaults (stops paying) you are pretty much out of luck. Your options are using a collection agency (costs more than it’s worth) or sell your loan on a secondary market (again takes time).
- It takes time to find the right loans to invest in. Sometimes you login and there are a bunch of great looking loans that meet your criteria, other times…not so much.
- There is a learning curve, you undoubtedly will have no idea what makes a good investment when you start, which is totally okay. There are a ton of blogs and resources you can read to educate yourself. Here is a list of the top peer to peer lending blogs.
How does peer to peer lending fit into your overall investment strategy
I hesitate to put this section in here because it really depends.
A majority (80%) of my investments are in more traditional investments like a 401k, individual stocks, and a few ETFs and bonds.
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Prosper and LendingClub share their default rate data with you and it’s widely accepted that 100 loans at $25 each (or $2,500) is a pretty good number to be diversified. This number of loans should keep you in the game and your money growing but it’s up to you to do the research.
I view this alternative investment option as a way to learn about how lending works and how to be more active with my investments. I can try and target an ROI and buy the loans I need to get me there.
As of this writing, I am getting just under 8% returns on my investment and I normally buy AA, A, B, and a few C level loans. The majority of my loans are A.
Wrapping It Up
At the end of the day peer to peer lending might not be right for you and your investment goals, but I think it’s important to know what is out there. As millennials, we are living in the golden age of information.
I would encourage you to actively seek new and exciting ways to invest your money and challenge common beliefs. What got us here won’t necessarily get us there.
Your financial education is on your shoulders and it’s important you are always exercising your money muscle (your brain).
I am curious. Have you given peer to peer lending a try? If so, drop me a comment on your experience and what your thoughts are on my article on peer to peer lending explained.