I recently received a reader question about Peer to Peer Lending, and I would like to share the answer with everyone.
Prosper and Lending Club have become very popular. Are Person to Person Loans guaranteed?
First, let’s address the popularity of P2P lending: Prosper and Lending Club have become popular because the P2P lending process gives people another option for lending and borrowing money. The lending and borrowing process bypasses banks. The advantage of these loans is that they can offer borrowers a lower interest rate and give individual lenders the opportunity to lend to individuals and potentially earn more money than they could earn in a CD.
Peer to Peer Loans Are Not Guaranteed
Now, to answer the main question: The short answer is no. The rate of return is not 100% guaranteed. However, the P2P lending process is safe in that it has a defined lending process, is a legal loan, and is reported to credit agencies.
The P2P Lending Process
The process works very similar to a financial institution making an unsecured loan to an individual. The borrower’s ID and financial history is verified, their credit score and history is investigated, and their debt to income ratio is determined. From this information, the lenders assign a base interest rate for the loan. The risk is similar to the risk a bank assumes when they underwrite an unsecured loan to an individual.
Prosper agrees to fund the loan on the condition that enough “lenders” agree to buy the loan from Prosper when it is funded. So actually, the “lenders,” people like you and me, are buying a piece of a legal loan that was made by a financial institution (in this case, Prosper).
Once the loan is made, the borrower pays the funds to Prosper, which then doles out the payments to the lenders. If a payment is missed, late fees are assessed to the borrower. If the loan goes into default, it goes against the borrower’s credit report and there are collections agencies to collect the money. Skipping out on a P2P loan has the same consequences as skipping out on a personal loan made by a financial institution.
So no, the loans are not 100% guaranteed, just like an unsecured personal loan from a financial institution to an individual is not guaranteed. But it works exactly the same way and has the same consequences to the borrower.
Why Lend Through P2P Lenders if the Loan Isn’t Guaranteed?
The P2P Lending process allows individuals to “be the bank,” and have the opportunity to earn more money than they could otherwise earn in a savings account or CD. Prosper and Lending Club make their money by taking a small cut of the final loan value and other service fees. When it works properly, everyone is happy – borrowers get a better rate on their loan, lenders get better interest rates on their investments, and the P2P company takes a small cut from each loan.
There is Risk Involved
As with any investment, you should do your research before investing. Some P2P borrowers are people with very high credit scores, and low credit risk. However, that does not mean the loan is a guarantee. Other borrowers have very poor credit scores or history, and the interest rates are usually higher as a result. Lenders are assuming the same risks that banks assume when they make an unsecured loan to an individual.
Protect Your Investment
The best way to protect your investment is to make informed decisions on which loans to fund, and to diversify your loans by spreading your investments among several borrowers. Loans can be made through Prosper for as little as $50, and through Lending Club for as little as $25. This makes it much easier for lenders to loan small amounts to a.) more easily fund loans with a small initial investment, and b.) diversify their loans to decrease the risk of any one large investment going into default. With P2P lending, diversification is paramount.