What is Peer to Peer Lending?

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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…

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
  • Funding Circle
  • Kiva (Kiva offers loans to people in 3rd world countries; lenders only receive their principal 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.

Do 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 your 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 could 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.

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About Ryan Guina

Ryan Guina is the founder and editor of Cash Money Life. He is a writer, small business owner, and entrepreneur. He served over 6 years on active duty in the USAF and is a current member of the IL Air National Guard.

Ryan started Cash Money Life in 2007 after separating from active duty military service and has been writing about financial, small business, and military benefits topics since then. He also writes about military money topics and military and veterans benefits at The Military Wallet.

Ryan uses Personal Capital to track and manage his finances. Personal Capital is a free software program that allows him to track his net worth, balance his investment portfolio, track his income and expenses, and much more. You can open a free account here.

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