In one sense, peer to peer lending is as old as humankind. At some point, one caveman lent another caveman an axe, and we’ve been borrowing and lending ever since.
Traditionally, lending was limited to people who were close enough – geographically and personally – to perform the transaction. In other words, family and friends would lend money to each-other. Otherwise, borrowers would have to turn to a financial institution such as a bank.
Modern technology has changed all that. Peer to peer lending sites harness the power of the internet to bring together borrowers and lenders from across the world. For borrowers, this represents an alternative to traditional bank loans.
For investors, it means the opportunity to earn interest on a personal loan – just like a bank does. As an investor, you can connect with borrowers from around the globe. You can choose your level of risk and invest small or large amounts.
So, how do peer to peer loans work, and are they the right investment for you? Here’s everything you need to know about this new technology.
P2P Lending Basics
Peer to peer lending works a bit differently depending on the platform. Different P2P lending platforms offer different loan terms and interest rates. They also use different metrics to determine a borrower’s creditworthiness. That said, let’s talk about the fundamentals.
P2P loans are loans from one person – the lender – to another person – the borrower. Lenders are also known as investors, because they’re expecting to earn a return on their money. Most P2P loans carry a fixed rate, and are fully amortizing. This means that if the buyer makes all of their payments on time, the loan and interest will be fully paid off at the end of the loan term.
The loan process begins with the borrower, who submits an application to the lending platform. This application will include the loan amount, what the loan is going to be used for, and some basic credit information. The borrower may also be able to choose from different terms.
The platform then determines the borrower’s creditworthiness. Much like traditional banks, different platforms will have their own ways of doing this. Relevant factors can include the borrower’s credit score and debt-to-income ratio. Typical FICO score requirements are typically in the mid-600s, and most platforms won’t offer loans to subprime borrowers. The platform may also consider the purpose of the loan, the amount, and the requested term.
Based on all this, each borrower is assigned a credit grade. The grading system varies by platform, but some have up to 12 separate grades. Interest rates can be as low as 6.99% for the highest grades. Lower grades will pay higher interest rates.
At this point, investors can choose to fund the loan. An investor can fund an entire loan, or spread their investment out across several loans. Most advisors will recommend spreading your investment out to minimize your risk. That way, you won’t lose your entire investment just because a borrower defaulted on their loan.
Some platforms allow investments as small as $25, so you don’t have to be a high roller to become a lender. Platform fees are also reasonable, typically around 1% of your investment per year. That’s comparable to what you’ll pay on many alternative investments.
Types of Peer-to-Peer Loan
Different peer-to-peer lending sites will have their own selections of loan offerings. Here are the most common types of loans:
Personal loans – Personal loans are small loans, generally $35,000 or less. They can be used for just about anything, from home improvements to debt consolidation. The vast majority of P2P loans are personal loans.
Business loans – Many small businesses turn to P2P lenders as a source of financing. These small business loans have simpler application processes than traditional banks, and their requirements aren’t as strict. Depending on the platform, borrowers can access as much as $500,000 in funding. That said, most platforms require a six-month track record, so P2P funding isn’t viable for a brand new startup. The business may also serve as collateral.
Mortgage loans and refinancing – Some peer-to-peer lending sites offer mortgages and refinance options. In most cases, these are only available for owner-occupied properties. It’s difficult, verging on impossible, to obtain funding for a rental property. For an ordinary mortgage, most lenders will require a 10% down payment, but borrowers will not be required to obtain mortgage insurance. Depending on the size of the mortgage, this can be a substantial monthly savings for the borrower.
Medical loans – When health insurance doesn’t cover a procedure, many people turn to loans as an alternative. P2P platforms offer medical loans in amounts as high as $32,000, enough to cover the cost of cosmetic surgery, fertility treatments, and other commonly-excluded procedures.
Student loan refinancing – Peer-to-peer lending can be an excellent value for student loan refinancing. Platforms will take job experience and education into account, not just the borrower’s credit score. Borrowers who rate favorably can save money by bundling up to $500,000 in debt into a single, lower-interest loan.
Auto loans – P2P platforms don’t offer auto loans – at least not yet. But many borrowers take out a personal loan for the purpose of buying a car. This represents a trade-off. On the one hand, since it’s not a true auto loan, the borrower’s car doesn’t serve as collateral. And with $35,000 to play with, you can borrow more than enough to buy a car. On the other hand, because there’s no collateral, the interest rate will be higher.
Peer-to-Peer Lending Pros and Cons
Like any other investment, peer-to-peer lending has its own benefits and drawbacks. Here are some reasons you might – or might not – want to consider it.
Monthly payments – To earn money on most investments, you have to sell them. This means keeping an eye on the market and selling at the right price. Peer-to-peer loans pay you back on a monthly basis. It’s a passive source of income, similar to owning a dividend stock.
Better returns than the stock market – No investment is guaranteed. Make the wrong loan, and you could lose all your money. That said, savvy P2P loan investors can beat the stock market. A 10% annual return – or even higher – is not out of the question.
Low minimum investment – Some peer to peer lending platforms require as little as $25 to start investing. Just about anybody can start earning a monthly return.
Diversification – Peer-to-peer lenders can spread their investments across multiple loan packages to minimize their risk. They can invest in loans with shorter and longer terms. They can even choose a mix of high- and low-risk loans.
Convenience – Many platforms come with automation features so lenders can set up regular monthly investments. You decide what kinds of loans to fund and how much to invest, and the platform does the rest.
IRA options – A handful of platforms offer IRA options. You can put your investments directly into an IRA or, or roll over your 401(k). This gives lenders tax privileges they don’t get from many types of investment.
Poor liquidity – There is virtually no secondary market for peer to peer loans. Once you fund one, your money is tied up for the duration of the loan term. This makes them a poor choice for emergency funds and short-term savings.
Possible default – With a traditional investment, you can get some of your money back. Stocks often go down in value, but unless the company goes out of business, you’ll be able to recover something. With a P2P loan, you rarely have any collateral. If the borrower defaults, the lender receives nothing.
Difficult to manage – Since the borrower’s monthly payments include both interest and principal, it can be a headache for lenders to reinvest their principal. You have to manually separate the principal from each payment, which can become a pain if you’re juggling multiple loans.
No FDIC insurance – A P2P loan is not like a savings account or a money market account. If the platform fails or goes out of business, your money could disappear into the ether. That said, some platforms have made arrangements with other platforms to take over their portfolios if they become insolvent. Before you choose a platform, do some research and find out what their contingency plans are.
P2P Lending: Risk vs. Reward
Peer to peer lending is like any other investment; you need to strike a balance of risk versus reward. In practice, this means diversifying your investments.
Most P2P lending platforms allow you to invest as little as $25 in any given loan. So don’t put all your eggs in one basket. Instead, spread your investment out across different risk levels. Higher-risk loans will earn a higher interest rate in a strong economy, but are more likely to default in a weak one. The converse is true for lower-risk loans. The return will be lower, but there’s less risk of default if the economy turns sour.
The perfect balance will depend on your risk tolerance. If you’re investing for fun or can afford to take a loss, go ahead and invest more money in higher-risk loans. If you’re carefully nursing your nest egg, you’ll probably take a more conservative approach and maybe consider if P2P is a suitable asset class for your portfolio.
Along the same lines, it makes sense to invest in multiple different loans, even within the same loan class. Remember, you can break up your investment into $25 packages. If you’re investing $500, you can theoretically spread that across 20 separate loan packages.
Long-term investors will also want to reinvest their principal. The amount of interest in each monthly payment goes down, and the amount of principal goes up. Fail to reinvest that principal, and your returns will eventually trickle out. Long-term investors will want to do this on a monthly basis.
Finally, remember that P2P loans themselves are not very diverse. A sudden economic downturn can cause swathes of borrowers to default. A good investment portfolio will include stocks, bonds, ETFs, and other securities. Peer-to-peer lending should be a relatively minor portion of your portfolio.
In the current environment, expect to see P2P lending rates between 6% – 15% depending on loan specifics and credit worthiness.
Should I Invest in Peer-to-Peer Lending?
Peer-to-peer lending can be a good investment for some people, and a poor choice for others. Before you decide where to put your money, it’s essential to understand the risks.
Ultimately, P2P lenders are providing unsecured loans to individual borrowers. This kind of debt is notoriously risky. Most people pay all their debts when times are good; after all, nobody wants to take a hit on their credit report. But times aren’t always good, and people have other bills like their mortgage and car payments. Failure to pay these bills comes with severe consequences, so personal debt is the first debt they default on.
This isn’t always predictable. The Covid-19 pandemic is a good example of an unexpected event that caused millions of people to default on their loans. Peer to peer lenders who made a bunch of investments in January of 2020 were some of the biggest losers.
That’s no reason to avoid peer-to-peer lending sites altogether. But it’s a good reason to balance out your portfolio with some safer investments.
The Top Peer-to-Peer Lending Sites
Choosing the best peer-to-peer lending site is a personal matter. A lot will depend on your investment philosophy and what you’re trying to achieve. Here are five of the most popular platforms for borrowers and investors.
Founded in 2005, Prosper was the first peer-to-peer lending site to offer services to the public. Over the past 17 years, they’ve administrated more than $22 billion worth of loans. They offer loans with terms of 2 to 5 years, with an APR that ranges from a modest 6.99% to a hefty 35.99%.
Prosper helpfully sorts their loans into seven categories, based on the estimated rate of default. AA loans have an average default rate of 1.99% or less, and provide the lowest interest. HR (High Risk) loans have a default rate of 15% or more. Keep in mind that these are just estimates. Default rates will vary based on market conditions and other factors.
That said, even the highest-risk borrowers have a higher-than-average income and credit score.
BlockFi is an unusual P2P lending platform that offers collateralized loans. They perform no credit checks on their borrowers and provide their loans instantaneously. However, borrowers must first deposit their cryptocurrency into an escrow account to serve as collateral. If the borrower defaults, BlockFi sells the cryptocurrency and provides partial repayment to the lender.
As a result of this approach, BlockFi is able to offer very low rates, earning lenders a 4.5% to 9.75% return. This isn’t as high as most other platforms, but the collateralized nature of the platform makes it much safer. BlockFi loans also provide a faster turnaround than other P2P loans, with a term of only 12 months.
In addition, BlockFi also offers interest-bearing cryptocurrency accounts. Unfortunately, this service is not available in the US, due to SEC regulations.
Upstart is more than a peer to peer lending platform. They earns much of their income from their banking software. But the intuitive lending interface has also been a big hit with the public. Lenders can automate their investments by choosing a strategy once and setting up regular payments.
This innovative, engineering-driven approach only makes sense, given the company’s origins; it was founded by three former Google engineers.
This extends to the way Upstart evaluates borrowers. Instead of making their decisions based on a credit score, they use a combination of artificial intelligence and machine learning to make their rankings. The result is a much lower default rate than many lending platforms.
Terms for an Upstart loan range from 3 to 5 years, with an APR ranging from 5.6% to 35.99%. The platform has tripled in size in the past three years, with borrowers and investors attracted by their AI underwriting.
SoLo Funds is one of the best peer to peer loan platforms for short-term debt. A SoLo Funds loan is similar to a payday loan, with a maximum term of 35 days. Borrowers do not pay interest, but instead pay a tip in an amount of their choice. The higher the tip, the faster an investor will be likely to fund the loan.
The loan amount is capped at $575, and there’s no minimum amount for lenders. That’s a huge benefit for small-dollar investors, since you don’t have to put out a lot of money all at once.
The SoLo Funds loan marketplace lists each loan, along with the promised tip. Borrowers are ranked on a scale from 40 to 99, with higher scores representing a more reliable borrower.
Better yet, SoLo Funds offers more security than most other P2P lending platforms. If borrowers go into default, their account goes to a third-party collections agency. Investors can also purchase loan insurance for a small fee.
Funding Circle is the best peer lending platform that’s purpose-built for small businesses. They provide a robust 11.29% to 30.12% APR, and they receive collateral in the form of the business itself.
Unfortunately, Funding Circle requires a minimum investment of $25,000.
P2P Lending Alternatives
If P2P lending sounds too risky, then it may not be the right asset class for you. I have experimented with various alternative investments, and P2P is just one of many easily accessible for most individual investors.
Peer-to-peer lending can deliver impressive returns, provided your investments are well-diversified. It’s also important to choose a platform that meshes well with your needs. For example, if you want to invest in small businesses, look for a platform that offers small business loans.
And remember – P2P investments should only be a small part of your portfolio. If there’s a recession, you’ll thank yourself for being in less risky assets.
Josh is a financial expert with 15+ years on Wall Street as a senior market strategist and trader. Josh graduated from Cornell University with a business degree in Applied Economics and has held numerous U.S. and European securities licenses. In addition to running an investment and trading firm, Josh is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses himself.