As cutting edge as it now sounds, the underlying concept supporting peer-to-peer (P2P) lending has been around for centuries. While the Financial History Review cites examples of the practice in pre-industrial France as some of the earliest instances of P2P loans, it can be reasonably argued people have always engaged in lending and borrowing.
The difference today is the practice is no longer limited to agreements between individuals who reside within immediate physical proximity of one another. The proliferation of the Internet has spawned online platforms upon which people lend and borrow. This, in turn, has led to global opportunities for investing in peer-to-peer lending.
David Nicholson, one of the founders of what is regarded as one of the first P2P lending platform, Zopa, is quoted in a Bank of England Working Paper as having been inspired to develop an alternative to the banks that were sitting between depositors and borrowers. While the lending process looked somewhat complicated from a distance, Nichols realized the basic mechanics were quite simple, particularly since he and his partners could leverage the internet to bring lenders and borrowers together.
How P2P Lending Works
Platform aside, P2P lending is basically a transaction between two parties — the lender and the borrower. Lenders, also known as investors, are looking to earn a profit on the loan, while the borrower uses the funds for whatever purpose they deem necessary. In most cases, P2P lending is based upon fully amortizing, fixed-rate loans. Interest rates remain constant for the term of the loans and payments are made in equal installments according to set schedules.
A borrower submits an application covering basic information such as the requested loan amount, the purpose of the loan and an agreement to an evaluation of their credit history. Loan terms average between three and five years. Interest rates average 6.99%.
Borrowers are rated according to “credit grades,” of which there can be as many as 12. Rating parameters include the borrower’s FICO score, their debt-to-income ratio, the amount of the loan, the purpose of the loan and the desired loan term. The minimum credit score is generally in the mid-600 range. Individuals with recent bankruptcies, judgments and/or tax liens are precluded from borrowing. In other words, applications from sub-prime borrowers are usually turned down.
Investors can fund entire loans or parts of loans. The latter is usually recommended, since it reduces the risk of your entire investment going sideways if a single borrower defaults. Such notes can be had for as little as $25 each. Administrative activities handled by the platform include underwriting, as well as closing and distributing loan proceeds. The platform also manages lender remuneration. These services are provided in exchange for a 1% administrative fee. Some investors report average annual returns of more than 10%.
P2P Loan Types
Loan types vary from platform to platform. However, the most common kinds are personal, auto, business, mortgages and refinancing, student loan refinancing and medical.
•Personal loans are the most common type offered by P2P platforms. These are generally used to consolidate debt, or finance home improvements and the like. The cap on personal loans is $35,000 on most sites.
• Auto loans from P2P sites are not necessarily referred to as car loans per se. However, with a personal loan ceiling of $35,000, the purchase of an automobile with the funds is more than possible. This can be a particularly attractive prospect for a borrower, as the car does not have to be pledged as collateral to secure the loan.
• Business loans secured from P2P sites tend to have more relaxed requirements than those from banks. They also require less documentation. Still, they aren’t really a source of startup cash, as most sites require borrowers to have a track record of at least six months. Some platforms will lend as much as $500,000 in this area. These loans are often collateralized by a general lien on the business.
•Mortgages and refinancing offered by P2P platforms usually apply to owner- occupied residences —either primary or secondary. Applications for funds to purchase rental properties or buying into a co-op are usually turned down. Borrowers are asked to provide a 10% down payment and the purchase of mortgage insurance is not a requirement. Loan origination fees are not charged, and the cap is typically $3 million.
• Student loan refinancing is another specialty of the P2P marketplace. Students can combine up to $500,000 in student loans from multiple lenders, assuming their credit history and income will support such a decision. In addition to income and credit history, many of the P2P platforms operating in this area look at career experience and education.
• Medical loans can be applied to dental work, fertility treatments, hair restoration and weight-loss procedures, most of which are excluded from coverage by typical insurance policies. Loan amounts can be as much as $32,000, with terms from two to seven years.
Pros & Cons of P2P Investing
As with any other type of investment, there are upsides and downsides of which to be aware. In the case of P2P investing, the upsides include:
• Low Barrier to Entry – A P2P portfolio can be created with a minimal amount of capital, making it one of the least costly forms of investing in which to participate.
• Monthly Income – Investors are paid every month when borrowers make payments on their loans. This means a solid portfolio of P2P loans can generate a steady stream of passive income.
• Higher Yields – Without question, the single most attractive aspect of P2P lending for investors is the potential for higher yields. A carefully curated portfolio of loans can potentially earn 10% annually or better.
• Specific Control – Investors can determine the types of loans they’ll fund, as well as the term, credit score range and debt-to income ratio of borrowers with whom they are willing to work. Some platforms offer tools for automating this process, so an investor can set specific guidelines and turn their attention to other matters.
• IRA Friendliness – Some platforms offer lenders the capability of setting up a standard IRA, a Roth IRA or rolling over a 401(k). This offers tax advantages in that gains can be deposited directly into these accounts.
•Loan Diversification – Investors have the option of funding entire loans or purchasing notes in increments as small as $25 each to spread risk across a variety of loans.
The downsides to consider include:
•Potential Defaults – As you may have observed above, the vast majority of P2P loans are unsecured. This means they have no collateral backing them. Further, these are loans to individuals. Your investment will evaporate if a borrower defaults, especially if it’s early in the term of the loan.
• No FDIC Protection – Investors are not reimbursed by the Federal Deposit Insurance Corporation when P2P platforms fail. Nor does the FDIC cover investor losses if a borrower defaults. Some platforms do have agreements with other platforms to manage loan portfolios if they go out of business, but there are no guarantees.
• Capital Depletion – Principal and interest payments on loans are recovered simultaneously. This is different from traditional securities in which the total amount of your original capital is returned at the end of the term. This places the onus on the investor to separate principal and interest as payments are made or reinvest the proceeds altogether.
•Lack of Liquidity – As of this writing (February 2023), the secondary market for P2P loans are practically non-existent. For this reason, a P2P investment is best thought of as a buy-and-hold proposition. You’ll have to offer a rather significant discount to find someone willing to buy a portfolio P2P of loans from you.
Balancing Risk and Reward
As with any other investment vehicle, a common approach to minimizing risk is diversification. Toward this end, shares in loan packages can be purchased for as little as $25 each. This means a $1,000 investment can theoretically be spread over 40 loans. In addition to scattering your investment over a number of different loans, you can employ a variety of P2P platforms. After all, peer-to-peer lending sites do go under from time to time. With all of your dollars in a single vessel, your entire investment could founder if it sinks.
Diversification also means spreading your capital over a broad range of credit grades. One of the fundamental aspects of investing is the fact that risk and reward tend to go hand in hand. Generally speaking, the more risk you’re willing to assume, the greater the potential reward you could reap. While focusing only on the top credit tiers can potentially ensure minimal risk, your yields will be less significant than if you branched out into some lower-grade loans. With that said, you do want to avoid potentially higher risk categories.
Finally, you’ll want to keep P2P ventures to a relatively small percentage of your fixed-income investments. While the potential for a double-digit return is quite enticing, committing your entire portfolio to that pursuit is asking for disaster.
Reinvesting your loan payments may also be critical to the successful execution of a long-term P2P strategy. Remember, these loans are self-amortizing. This means returns diminish as loans get closer to term. Moreover, your principal is repaid in installments — along with the interest. Continually purchasing new notes is central to staying fully invested in P2P lending.
Regulations
Although P2P lending has been around for centuries, it is still a relatively new industry that is yet to be fully regulated. This means that as an investor you need to be careful when selecting a platform to invest in, and you should understand the regulations that govern P2P lending. In the US, the SEC only started regulating P2P lending platforms in 2008. So it’s a young industry in terms of regulation and rules. It’s essential to check whether the platform you’re considering investing in complies with the relevant regulations to ensure that your investment is protected.
In 2016, New York state issued “warning letters” to 28 P2P lenders, threatening to require them to obtain a license to operate unless they complied with demands to disclose their lending practices and products available in the state. This serves as a reminder that investors should carefully research the platform they are considering and understand the regulations that govern P2P lending in your state.
In other words, understanding the regulations can also give you more confidence in the platform and help you make informed decisions.
Is P2P Investing For You?
It is important to understand the risks of any investment asset. This is particularly true when it comes to P2P investing. After all, the foundation of these investments is unsecured loans to individuals.
Yes, peer borrowers are pretty well vetted and you’re given a relatively good idea of their ability to service the debt. However, human beings don’t always perform as expected. Moreover, a sharp economic downturn, such as the one brought about by the COVID-19 pandemic, could trigger a collapse if people are unable to earn money to repay the loans.
These are important considerations to ponder as you’re weighing the pros and cons of adding a P2P lending component to your portfolio. A good rule of thumb here is to invest no more than you can comfortably afford to lose altogether.
