What is Peer to Peer Lending?

by Ryan Guina

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 a lot of 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 if they choose. 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 actually 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 are able to 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 will 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 essentially assuming the same amount of risk a bank would, just on a smaller scale.

The Person to Person Lending Process

The lending process is set up just similar to a financial institution providing a personal loan to an individual. The loan is a legal loan 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 a bank account for verification. They also provide income level and profession. This info is used to verify the borrowers 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 alike.

Defaults: If a borrower defaults on a loan, it is reported to the major credit agencies and there are established collection agencies to go after the money for the lenders. A loan from Prosper or Lending Club is a legal loan, just as if it originated from a brick and mortar bank.

One small difference – Lenders aren’t actually lenders. The loan is actually made by Prosper with their own 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 really 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, and 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.

Which companies offer peer to peer lending?

There are actually 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
  • Pertuity Direct (no longer funding loans)
  • Kiva (Kiva offers loans to people in 3rd world countries; lenders only receive their principle 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 which creates multiple streams of income. As the loans get repaid, the lender has the option of lending the money in new loans or withdrawing the money.

Does 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, but also 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 of the P2P lending companies offer plans that are already diversified and offer a “target” return. There is no guarantee the return will actually meet the target, but it is designed to get you there. Prosper is currently advertising average lender returns 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 the risk.

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 you 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 ccould afford to put at risk. Just like any other investment, you need to do your 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 do your research to determine 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 quite possibly be better than a CD or high interest bank account.


Published or updated October 11, 2016.
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{ 21 comments… read them below or add one }

1 AEL

IF YOU GO AHEAD, PUT ALL IN WRITING
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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2 Ryan

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.

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3 Pinyo

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

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4 Laura

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

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5 Ryan

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.

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6 Ricardo Bueno

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.

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7 Ryan

Pinyo, Thanks. I think there is a lot of opportunity in this field.

Ricardo, Sounds interesting!

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8 CiaranFromChance

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…

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9 Ryan

Ciaran,

I agree, this is an interesting concept and I’m looking forward to learning more and sharing it with everyone.

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10 fathersez

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.

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11 Ryan

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.

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12 Jose

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.

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13 lulugal11

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.

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14 Mrs. Micah

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.

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15 Adfecto

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).

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16 Ryan

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.

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17 Adfecto

@ 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.

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18 Brian

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.

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19 Ryan

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.

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20 JJ

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.

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21 Ryan

Hi JJ: I only purchased a few top rated loans. I never had any late payments and have earned over 11% so far.

Here is an update from my experiences: P2P Lending Update.

If you are interested in signing up for Lending Club, you can get a $25 bonus, which will be enough to fund your first loan through LC: $25 Lending Club Bonus

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