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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.

Here is a CBS video that explains P2P lending:

Who benefits with peer to peer 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.

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
  • Pertuity Direct
  • Prosper
  • 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 it take 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 peer to peer 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.


Published or updated March 20, 2014.
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{ 15 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 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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13 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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14 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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15 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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