What’s Peer-to-Peer Lending?

I’ve been looking into peer-to-peer lending as a possible “outside the stock market” investing option and like the idea of helping other people start businesses or get out of debt. What are your thoughts?

–Jen, Flagstaff, AZ

I’m happy to see this growing trend of out-of-the-box (or stock market, in this case), non-traditional investing options emerging. Over the past decade, and certainly following the market crash in 2008-2009, the public has increasingly demanded Wall Street alternatives and technological advances have helped deliver them. This is great news for many of us looking to grow or borrow money in a more feel-good and less impersonal kind of way.  

Peer-to-peer lending (aka “Person-to-Person” or “P2P”) is one of those non-traditional financial concepts. Basically, it is a form of short-term lending and borrowing (loans typically have a 3-5 year term) between individuals that eliminates financial institutions from the equation. The best feature of P2P lending to borrowers is not being subjected to the stricter credit requirements and higher interest rates typically imposed by traditional lenders. 

For the lenders (who are essentially investors), the main attraction is a return on investment that can be far above average (compared to other short-term investments) with relatively low risk. The other features are dependable monthly income and, maybe most importantly, the ability to invest directly in people and have a positive impact on the lives of individuals (who may be good people trying to get out of bad debt or entrepreneurs looking for seed money). 

There are several companies today offering users a platform to participate in P2P lending. The two most popular ones are Lending Club and Prosper.com. Lending Club recently got a $125-million investment from Google — which obviously believes in their potential appeal — and has funded nearly $2 billion dollars in loans. Prosper.com seems to have experienced more growing pains and has funded around $500 million in loans. Earlier this year the company overhauled their leadership, partnered with a big-time venture capital firm, tightened their credit policy (due to a problem with borrower defaults) and updated their website in efforts to better compete in the rapidly expanding marketplace.  

Keep reading to learn more about the risks and returns of P2P lending.

Both platforms offer the option to browse individual cases and invest based on personal choice or the option to invest in a pre-selected, diversified group of loans based on desired level of risk. Some investors using both platforms claim to have gotten better returns through Prosper (where the minimum credit score for borrowers is 640) than Lending Club (where the minimum score is 660). 

P2P lending (at least through these two platforms) offers very tempting investing options. Who wouldn’t want a steady rate of return of at least 6 percent net of fees–and much higher in some cases–and the satisfaction of helping your fellow (wo)man in need? They both also offer IRAs, but the minimum investment is $5,000 and the diversification, cost, risk and long-term growth potential are questionable compared to other IRA options through more traditional brokerages

Keep in mind that the higher return investing options with P2P do come with higher risk, and both Prosper.com and Lending Club charge a one-percent service fee to investors (for Lending Club it is charged to anything paid by the borrower and for Prosper.com it is charged to the annual borrowed balanced and is accrued daily) as well as fees for collection services in the event of payment delinquency. 

More importantly, not all states have approved this kind of investing yet, so if you live in Arizona or Pennsylvania, for example, you can’t currently invest in P2P through these platforms (bummer, I know). And other states require that you have a minimum net worth and/or minimum annual income in order to invest this way. 

Bottom line: P2P investing is definitely a compelling and seemingly rewarding alternative to traditional investing. However, it requires extensive research to make sure that (A) you are even eligible to be an investor, (B) the risk and return potential are aligned with your investing goal and risk tolerance, and (C) you are investing in people you truly want to be supporting (and who have a high likelihood of paying back the loan).

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