Peer-to-peer lending has become an area of interest for yield-seeking investors in recent years as savings and bond rates continue to disappoint.
Peer-to-peer lending, in which investors make unsecured personal loans to consumers and are often rewarded with average annual returns of 7, 9—or even 11%, might seem like a solution to disappointing returns in other areas.
But peer-to-peer lending is a risky investment. Here’s what you should know before you create an account.
How peer-to-peer investing works
Peer-to-peer is essentially non-bank banking. Just like banking, peer-to-peer is about making loans and returning the proceeds of those loans to investors, but peer-to-peer cuts out the “middle man,” which is the banker. Rather than investing your money through a bank—in the form of money market funds and certificates of deposit—you actually invest directly in the loans taken out by borrowers on peer-to-peer platforms like Prosper.
For example, borrowers come to peer-to-peer lending sites and fill out a loan application. They provide basic information, including loan amount and the purpose of the loan, as well as a general evaluation of their credit. That information is then made available to prospective investors, who can choose which loans they want to invest in.
On a typical peer-to-peer site, the borrower can borrow up to $35,000 in the form of an unsecured personal loan. The term of the loan usually runs between three years and five years, and the proceeds can be used for just about any purpose.
Loans are priced based on credit grades, and there are usually at least a dozen grades. Grades are based on numerous factors including:
- The borrower’s credit score
- Income (debt-to-income ratio)
- Loan amount
- Loan purpose
- Loan term
On the credit side, contrary to popular belief, most peer-to-peer sites do not handle subprime borrowers. In fact, the minimum credit score is usually at least 600, and more typically in the mid-600s. In addition, they don’t normally make loans to people who have recent bankruptcies, judgments, or tax liens.
One of the biggest advantages to investors is you do not have to purchase whole loans. Instead, you purchase “notes”, which are tiny slivers of loans in denominations as low as $25. In this way, you can spread a relatively small amount of investment capital across many different notes, reducing the risk that your investment bill wiped out by a single loan default.
The platform handles all of the administrative tasks of the loans, including underwriting, closing, distribution of loan proceeds, and collection of monthly payments. Those monthly payments are then remitted to you on each loan, less a 1% management fee to the platform. That means that your only responsibilities in the process are to select which loans to invest in, and then to sit back and collect the payments on each loan.
The major players in the peer-to-peer universe
Peer-to-peer is fairly new as an online process, with the first large-scale site beginning operations only in 2005. Many platforms have hit the market since, but one notable one is Prosper.
Prosper was the first major peer-to-peer lender to come online, and they have since issued more than $6 billion in loans.
» MORE: Check out our experience in our full Prosper review.
The rewards of peer-to-peer investing
Investor interest in peer-to-peer lending has grown steadily over the last few years in light of the zero interest rate environment, in which it’s very difficult to earn interest on fixed-income assets for anything more than 1% per year. Peer-to-peer investing provides a high-yield alternative, as well as other advantages.
High rates of return
Many peer-to-peer investors report annual investment returns of greater than 10%. That’s hardly surprising—typical loan rates offered by the platforms range between 6% and 36%. A portfolio of blended credit grades can easily earn double-digit returns, even when you subtract the 1% management fee and a reasonable allowance for loan defaults.
Build your own portfolio
On peer-to-peer platforms, you have more control over the specific investments than you do with most other investment vehicles. You can select notes based on certain criteria, including loan type, loan term, credit-score range, and debt-to-income ratio. In this way, you can control the variables surrounding your individual investments. And there are even online services that can automate this process for you.
You can set up an IRA on some P2P platforms
In addition to maintaining a regular investment account, you can also set up an IRA, Roth IRA, or a rollover 401(k) account. That means that you can add the higher returns of peer-to-peer investing to the fixed-income portion of your retirement portfolio.
You don’t have to fund entire loans
This gets back to investing in notes rather than whole loans. Since notes can be purchased for just $25, a $5,000 investment can be spread across 200 loans, enabling you to diversify with a very small amount of money.
But the news on peer-to-peer investing isn’t all positive…
The risks of peer-to-peer investing
Any time you see an opportunity to earn higher-than-average returns on your investment, it should be a given that certain risks will be involved. Peer-to-peer investing works the same way. Here are some of the considerations…
Loans are unsecured and can default
Peer-to-peer investments are in loans made to individuals, and that means that they carry the risk of default. That risk is even greater because the loans are generally unsecured, so there is no collateral to go after in the event of default. It is conceivable that you could lose 100% of your investment on an early-term default. (This is why diversifying across hundreds of notes is so important.)
No FDIC insurance on your investment.
Unlike bank investments, peer-to-peer investments are not covered by FDIC insurance. That means you will not be reimbursed in the event of borrower default. You will also not be reimbursed in the event that the peer-to-peer platform fails, although they typically have backdoor arrangements with other institutions to take over the loan portfolios should that happen.
When you buy a certificate of deposit, a Treasury security, or a bond, you invest a certain amount of money and are paid interest while the security is outstanding. At the end of the term, you get your original principal returned to you. But that’s not how peer-to-peer investing works. Since you are investing in loans, and those loans are being gradually paid off within the loan term, the investment will deplete all the way to zero at the end of the term. If you do not reinvest the payments, and instead spend them, you will have no investment capital from that note when it ends. This is an important distinction that a peer-to-peer investor might miss.
P2P performance in a recession is an X factor
During the last recession, peer-to-peer investing was still in its infancy. There’s no hard data confirming how well peer-to-peer loans will perform during a time of general economic distress. What is known is that loan performance tends to decline in general during recessions. Exactly how that will play out in the next recession is open to debate.
The best way to balance rewards and risks
There are definite methods to successfully investing in peer-to-peer loans. The basic idea is to maximize returns while minimizing risks. Here are some of the basics in that direction:
We touched on this earlier, but it’s worth reemphasizing. Since notes are only $25, you should be fully prepared to invest in hundreds of them. This will minimize the loss to any one position in your portfolio.
Not only can you diversify your peer-to-peer loans, but you should also consider diversifying where you invest your money. In addition to peer-to-peer sites , you can also consider using a robo-advisor like Wealthfront to diversify your investments.
With Wealthfront you can build your own investment portfolio from scratch using a collection of its expertly vetted ETFs, selected by their research team. Or, to keep things simple, you can use one of Wealthfront’s existing portfolios. You still have the option to add or delete ETFs in order to make the portfolio suit your needs. After your portfolio is set up, Wealthfront will do the rest. They can automatically rebalance your portfolio, reinvest dividends, and even use tax-loss harvesting to minimize the taxes you pay on your investments.
» MORE: Read our full Wealthfront review.
Spread out your investment returns
Credit grading means that the best quality loans will have the lowest interest rates. But if you only invest in the top grade loans, your income potential will be limited to less than 5% per year. By mixing in positions in lower grade loans, you can increase those returns to double digits. The idea, of course, is to spread your capital across different loan grades, and to avoid those that are the highest risk.
If you spend any time browsing available peer-to-peer notes, you’ll quickly realize that it would be enormously time-consuming to hand pick even the 40 $25 notes that would comprise a $1,000 investment.
A company called NSR Invest offers a service for investors who want a managed peer-to-peer portfolio. For a small annual fee, NSR Invest handles portfolio strategy, diversification and reinvestment for you. Learn more in our review of NSR Invest here.
Limit your investment
Because of the potential for borrower defaults, particularly in a general economic downturn, you should limit your total peer-to-peer investment to a small percentage of your investment portfolio. For example, if you normally keep 25% of your portfolio in fixed-income investments, you may want to put a percentage of that into peer-to-peer investments as a way of increasing the overall return on that allocation, without dramatically increasing the downside risk.
Always reinvest loan payments
Since peer-to-peer investments are self-amortizing, you must be diligent about always reinvesting the loan payments that you receive. If you don’t, your returns will decline as the loans pay down. The idea is always to stay fully invested by regularly purchasing new notes.
If you think of peer-to-peer investing mainly as an activity to increase the fixed income portion of your portfolio, it should serve your investing needs well. But like all other risk investments, it should never be seen as an all-weather investment that dominates your portfolio.
Peer-to-peer lending gives investors a chance to earn competitive annual returns by investing in unsecured personal loans to other consumers through networks including Prosper.
Some peer-to-peer investors can earn double-digit returns, but there are significant risks, chiefly:
- Investments are not liquid (you must wait for the borrower to repay the loan before all of your principal is returned).
- A future economic recession could lead to widespread loan defaults leading to diminished returns and/or a loss of principal.