Imagine earning double-digit returns on your investments while helping others achieve their financial dreams. That’s the allure of peer-to-peer lending, an innovative investment model that connects borrowers directly with investors. But is it really a smart move for your money?
In this article, we’ll explore the risks and rewards of peer-to-peer lending so you can decide if it’s right for your investment portfolio.
What is Peer-to-Peer Lending?
Peer-to-peer (P2P) lending platforms like Lending Club and Prosper allow individual investors to fund loans for borrowers who may not qualify through traditional channels. Borrowers get access to funds, while investors earn interest on their money.
Here’s how it typically works:
- Borrowers apply for loans and are assigned risk grades based on credit history
- Investors browse loan listings and select which ones to fund
- Once funded, borrowers make monthly payments which are distributed to investors
- Investors receive principal plus interest, less the platform’s servicing fees
P2P lending can offer higher returns than many traditional fixed-income investments, but it also carries unique risks. Let’s take a closer look.
Rewards of Peer-to-Peer Lending
1. Attractive Interest Rates
P2P loans often provide interest rates in the high single digits to low double digits, which can be very appealing in a low-yield environment. Investors can earn significantly more than they would from savings accounts or CDs.
2. Portfolio Diversification
P2P lending represents an alternative asset class that behaves differently than stocks or bonds. Adding it to your portfolio can provide diversification benefits and potentially boost overall returns.
3. Helping Others
Many P2P borrowers are looking to consolidate high-interest debt or fund small businesses. As an investor, you can feel good knowing your money is helping others get on stronger financial footing.
4. Accessible Investing
Most P2P platforms have low minimum investments, often just $25 per loan. This makes it easy for beginner investors to get started, and for experienced investors to spread their money across many loans.
Risks of Peer-to-Peer Lending
1. Default Risk
The biggest risk in P2P lending is that borrowers stop making payments. If a loan defaults, investors can lose some or all of their principal. While platforms do make efforts to collect, there are no guarantees.
2. Platform Risk
P2P lending is still a relatively new industry. If a platform goes out of business, it could disrupt loan servicing and payments to investors. Stick with the most established players to mitigate this risk.
3. Liquidity Constraints
P2P loans are not traded on a secondary market. Once you invest, your money is tied up for the duration of the loan (often 3-5 years). You may be able to sell loans to other investors, but likely at a discount.
4. Untested Economic Cycles
P2P lending only became mainstream in the years following the Great Recession. It’s still unclear how loan performance will hold up during a prolonged downturn. Defaults could rise significantly.
Maximizing Your P2P Returns
If you decide to invest in P2P loans, follow these best practices to optimize your results:
- Diversify across many loans ($25-$50 per loan is plenty)
- Focus on loans with higher risk grades for better returns
- Reinvest your earnings to compound your growth
- Consider investing through a tax-advantaged account like an IRA
- Never invest money you can’t afford to lose
The Bottom Line
Peer-to-peer lending can be a lucrative way to earn passive income and boost your investment returns. But it’s critical to understand the risks involved and never overextend yourself.
As with any investment, start small and monitor your results carefully. Realistically assess your risk appetite and thoroughly vet any lending platform before investing. With a sensible approach, P2P lending can be a rewarding piece of a well-rounded portfolio.
Peer-to-peer lending offers the potential for attractive returns, but also carries default and liquidity risks. Understand the trade-offs before diving in.
Are you considering investing in peer-to-peer loans? What excites or concerns you most about this alternative asset class? Share your perspective in the comments below.
