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Investing

Peer-to-peer lending - is it a good investment path to go down?

Ronen Menipaz

Ronen Menipaz

30.06.2020

Peer-to-peer (P2P) lending has blossomed into a multi-billion dollar industry, creating numerous peer-to-peer investment opportunities due to the simple process behind it, low(er) and few(er) fees, and quick(er) loan approval when compared to traditional financial services. Driven by these benefits, the industry is likely to continue to grow and innovate, presenting an enticing option for both those who need the money and those who want to invest it. 

Instead of going to banks and brokers, people turn to each other, and we’re essentially helping each other. While that is a nice sentiment, we all want to take care of our money, so: peer-to-peer lending for investors – is it a good investment?

It’s both ‘yes’ and ‘no’ from me. 

How P2P investing works

All P2P lending platforms follow the same basic modus operandi: being the middleman between the two sides. 

As a lender, you are directly connected to a borrower (an individual or a business) who has an account complete with necessary financial details. The platform (aka marketplace lender) assigns a risk category (loan grade) based on credit history, income, type of loan, and the amount intended to borrow, which determines the interest rate the applicant will pay. Here is a table of loan grades and the corresponding interest rates from Peerform, one of the top peer-to-peer lending companies:

table of loan grades and the corresponding interest rates from Peerform

Generally speaking, only the most creditworthy applicants qualify for the lowest rates and longest loan terms. You review the profile/application and decide whether to fund the loan or not. If you choose to do so, the platform sets the rates and terms that direct the transaction, as well as handles the transfer of money and/or the recurring payments. 

Basically, you get to play the role of a bank for someone and get paid back the agreed-upon interest. Depending on the platform, the entire process takes anywhere between a few hours and a day or two, in some cases a week or two. Because they act as marketplaces, these platforms earn money by setting different fees on borrowers and taking a cut/percentage of the interest accrued on the loan, just as you get a higher peer-to-peer investing returns than returns through a savings account, for example.

What you gain

P2P lending is a favorable investment option if you’re looking to earn passive income. The biggest benefit is that interest rates attained in a P2P environment are higher than conventional interest rates.

Here is a hypothetical investor return data from Prosper, the industry’s veteran P2P lending platform. Both hypothetical investors invest $7,500 at a 23% lender rate, with a final loss rate of 10% after all loans are paid in full. They opt for different strategies: one bids on only 5 loans, while the other does so across 150 different loans.

a hypothetical investor return data from Prosper

Another thing that makes peer to peer lending for investors enticing is the fact that you can spread your money to more people, reducing the impact if one borrower goes into default. You can diversify your investments on multiple people and hedge yourself along the way (something you should always think about). You don’t even have to purchase whole loans as you can purchase so-called notes, which are pieces of a loan, sometimes for as little as $25 per loan for the US and $12/€10 in the EU.

In addition, most of these platforms provide features and data such as online borrower listings, average default rates, automated algorithms, and other helpful resources to make intelligent lending decisions. You have more control over the specific investments as opposed to most other investment methods. How much money you make depends on how much you are willing to invest and the type of loan (personal, debt consolidation, business loan, etc.). 

What should concern you

As usual, some level and form of risk is normal and should be accepted with any kind of investing, P2P lending included. There are some issues that personally put me off, beginning with the biggest one: defaults

Naturally, you can minimize your default rate by opting for higher grade loans, as well as performing in-depth research on the loans you are interested in. However, if you want more tangible returns, you’ll go for the riskier loans and you should know that loans are generally unprotected. Because the agreement is between a borrower and a P2P platform, you can’t do anything if the borrower doesn’t pay back the loan. Your losses won’t be covered because the borrower carries the risk of default (rare are the platforms that cover the costs of failed investments). 

Add to the fact there are typically no FDIC, FSCS, or any other insurances and there’s a whole new aspect of p2p lending risk management you need to be aware of. You won’t be reimbursed even in the event that the P2P platform defaults, although other institutions tend to take over the loan portfolios through specific agreements. 

Next, there is a certain risk of insufficient analysis of borrowers. Here is a screengrab lifted straight from the Prosper’s website:

a screengrab lifted straight from the Prosper’s website

What does that mean, on any level? Failing to thoroughly analyze the borrowers seems like a giant loophole people can easily take advantage of. 

Once you issue a loan, you have limited liquidity. Your money is tied for the next three to five years, assuming the borrower pays it off in time. Some platforms offer a secondary market where you can sell your notes sooner (not the ones on a loan that is in default), but usually for a steep discount.

Those would be the main issues for me. Make sure you check up on fees and taxes as well.

Peer-to-peer lending for investors – is it a good investment?

You’ll hear a lot of ‘yes’ votes and a lot of ‘no’ votes from a variety of investors. 

Right now, it’s a ‘no’ from me as economies around the world are in decline, which means default rates will likely go up. Unsecured debts like these types of loans will be among the first casualties. Plus, I’m not that comfortable investing in someone both I and, apparently, the platform don’t really know. 

Of course, you should do your own due diligence to determine if P2P lending fits your agenda and which platform suits you the best. This is a buy-and-hold strategy that can boost your returns if you diversify and limit your investments. Educate yourself to make sure it’s the right one for you.

Image credits:

https://www.peerform.com/investing/riskassessmentinterestrates/
https://www.prosper.com/plp/diversification/
https://www.prosper.com/invest

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