How to Start Investing in P2P Lending
Peer-to-peer (P2P) lending has become an increasingly popular way for individuals to invest their money over the last decade. It offers the potential for solid returns while providing loans to those who may not qualify for traditional financing.
However, P2P lending also comes with risks that every investor needs to understand. This guide will walk you through everything you need to know to get started investing in P2P lending.
What is P2P Lending?
P2P lending connects borrowers looking for loans with investors looking to earn interest on their money. The P2P lending company provides a platform that facilitates the transactions between the two parties. Typically, the loans are for unsecured personal loans, debt consolidation, or small business financing.
The appeal for borrowers is that they may be able to qualify for lower interest rates than traditional bank loans. The appeal for investors is that they can often earn higher returns than other fixed-income investments like bonds or CDs.
How Does P2P Lending Work?
The P2P lending process begins when a borrower completes an online loan application with a P2P lending platform. The platform evaluates the borrower’s creditworthiness and income and assigns them a credit grade and interest rate based on the level of risk.
Next, investors browse loan listings on the P2P platform and choose loans to fund based on the loan details provided. As an investor, you may fund a whole loan yourself or fractionally fund a loan along with other investors.
Once a loan is fully funded, the borrower receives the money minus any fees. The borrower makes monthly loan payments, which are distributed to investors according to the share of the loan they funded.
The Risks of P2P Lending
While the potential returns of P2P lending are attractive, this type of alternative investing comes with significant risks that every investor needs to be aware of before jumping in. The three major risks to evaluate are borrower defaults, platform failure, and liquidity concerns.
Borrower Default Risk
The most common risk P2P investors face is that of borrowers defaulting on their loan payments. Borrowers may pay late, partially, or stop making payments completely, which reduces the return investors receive.
According to data from dipping into your principal investment. Even quality borrowers can experience financial hardship from unexpected circumstances like job loss or medical expenses that prevent them from repaying as expected.
P2P platforms do have certain safeguards in place to minimize default risk, such as:
Thorough borrower vetting – Checking income, existing debts, credit score, and other metrics to analyze if they can reasonably afford the loan.
Risk grading – Assigning interest rates based on the borrower’s default risk so investors get compensated for riskier loans.
Late payment fees – Charging late fees to incentivize borrowers to pay on time.
However, defaults still happen even with quality borrowers. Historical default rates vary by platform from under 1% to over 5%. Higher is riskier for investors. The default rate should be a key factor in choosing a P2P platform.
Diversifying across many loans can help minimize the impact from any single default. But overall, the risk of borrowers not repaying as expected is inherent to P2P lending. Investors must be prepared for some level of missed or late payments.
Platform Failure Risk
Another risk to consider is the potential for the P2P lending platform itself to go out of business. The platform facilitates the transactions and repayment collection between borrowers and investors. If the platform failed for any reason, investors would likely have difficulty retrieving future payments on existing loans.
Big established P2P platforms like LendingClub and Prosper are unlikely to disappear overnight. But smaller platforms do carry higher failure risk, especially in economic downturns. Before the financial crisis, over 100 P2P platforms closed down.
To mitigate platform failure risks:
– Stick to large, reputable platforms that have been around for 5+ years.
– Check if the platform is a member of the Peer2Peer Finance Association which promotes operating standards.
– Look for venture capital backing and profitability as signs of stability.
No company lasts forever though. Platform failure may be unlikely but remains a possibility to prepare for.
Liquidity Risk
Finally, liquidity is a key concern with P2P lending. Liquidity refers to how easy or difficult it is to convert an investment to cash. With P2P lending, most loans are not sold on secondary markets so you cannot cash out early if you need the money.
If an unexpected need arose, you’d likely have to stop reinvesting payments received and wait for existing loans to mature before getting all your principal back. This may take months or years depending on the loans’ terms.
Options to increase liquidity include:
1- Using a P2P platform like FolioFN that does have a secondary market for trading loan pieces. However, selling at a discount may be required.
2- Keeping a portion of your capital in cash and bonds to cover emergency needs so you’re not forced to liquidate P2P loans early.
3- Only invest money you’re confident you won’t need access to for several years at a minimum.
The bottom line is P2P loans are illiquid investments that require a long-term commitment of capital. Investors need to be cautious about putting money into P2P that may be needed for near-term expenses.
How to Choose a P2P Lending Platform
Choosing the right P2P lending platform is a critical first step to succeed with this alternative asset class. The platform sets the borrower requirements, interest rates, expected returns, and overall investing experience. Do your research to find the best fit based on your investing goals and risk tolerance.
Here are the key factors savvy investors evaluate:
Reputation and Track Record
Favor P2P lending platforms that have established long track records of successful operations. The longer a platform has facilitated loans and payments smoothly, the better. Leading platforms like LendingClub and Prosper have been matching borrowers and investors for over 10 years since the early days of the industry.
Newer platforms may offer flashy rates to stand out, but also carry more uncertainty and risk. Stick to platforms that have weathered ups and downs for 5+ years to demonstrate stability.
Check online reviews and reports for any red flags about a platform’s operations or customer service. A solid reputation is a green flag.
Borrower Default Rates
Pay close attention to each platform’s historical borrower default rates, which directly impact your returns. Default rates vary widely across platforms and the types of borrowers they serve. Well-vetted prime consumer borrowers may default less than 1% of the time while riskier small business loans see 10%+ defaults.
All else being equal, favor platforms with lower default rates. But also consider how that aligns with your expected returns. Platforms serving only prime borrowers tend to have lower defaults but also lower interest rates.
There’s a balance between risk and reward. Know the default rates for each grade of loan so you can make informed tradeoff decisions.
Platform Skin in the Game
Some P2P platforms retain “skin in the game” by keeping a percentage of loans on their books. This aligns their incentives with investors to vet borrowers thoroughly. If borrowers default frequently, the platform loses money too.
Platforms without skin in the game may have more incentive to quickly originate many loans without as much diligence, while investors bear the consequences of defaults. Look for platforms with policies that retain 5-10% of issued loans.
Transparency
Reputable P2P platforms provide transparency into historical returns and expected default rates across risk grades. This helps investors set realistic expectations.
Look for detailed statistics on average returns, risk/reward analysis, and annual reports on default rates and performance. Platforms that provide robust data build trust with investors by demonstrating they have nothing to hide.
Automated Investing Options
Many P2P platforms now offer automated investing tools such as setting a target return and having algorithms automatically distribute funds across loans matching your criteria.
This can be an efficient hands-off approach once you know your target returns. However, watch out for hidden fees some platforms charge for automated tools that may eat into your profits.
Borrower Focus
Some P2P platforms specialize in certain borrower niches like consumer loans, business loans, student refinancing, etc. Consider which borrower category aligns with your sector expertise or analysis of loan performance.
For example, investing in consumer loans requires evaluating personal creditworthiness. Business loans depend more on projecting revenue and cash flows. Play to your strengths by focusing on a niche you understand.
In summary, evaluating P2P lending platforms on reputation, defaults, skin in the game, transparency, automation capabilities, and borrower focus allows investors to find their best fit. Do your due diligence before committing your precious capital.
How to Start Investing in P2P Lending
Once you’ve researched P2P lending platforms and chosen one that matches your criteria, it’s time to set up your account and put your capital to work. Follow these steps to start investing in P2P loans:
Opening a P2P Investor Account
The first step is signing up on your selected platform’s website for a new investor account. The process is similar to opening a traditional brokerage account. You’ll need to provide personal details including:
– Full legal name and contact information
– Social security number for identity verification
– Bank account details to link for transfers
– Employment and income details
– Tax identification numbers
Many platforms also require a short quiz to assess investing experience and risk tolerance. Once approved, you can fund your account and start browsing loans.
Funding Your Investing Account
You’ll need to transfer capital into your P2P account to fund loans. Most platforms accept bank transfers (ACH) and wires.
ACH transfers are free but can take 3-5 business days to appear in your account. Wires are faster but typically cost $10-$30. Some platforms also accept debit/credit cards for instant funding but may charge around 3% in fees.
Start conservatively by only transferring the amount you are comfortable investing initially as you learn the ropes. You can always add more capital later.
Choosing Loans to Invest In
Now the exciting part begins – browsing available loans and choosing ones to fund! Platforms provide searchable listings with loan details like:
– Borrower’s income, employment, credit score
– Loan amount, length, and purpose
– Interest rate and expected return
– Credit grade and default risk level
Filter and sort listings to find loans suiting your criteria for risk, returns, and loan purpose preferences. Click to view full details on promising listings before investing.
Diversify by investing small amounts across many loans rather than a few large chunks. Most recommend keeping any single loan investment below 5% of your total capital.
Automated Investing
Many platforms offer automated investing tools to save time. You specify target returns, risk tolerance, and other criteria. The system automatically distributes funds across appropriate loans matching your preferences.
This hands-off approach helps easily diversify while earning passive returns. However, watch for it investing too aggressively for your risk comfort level.
Monitoring Performance
P2P platforms provide investor dashboards to monitor loan payments and overall portfolio performance. You can see which loans are current, late on payments, or in default. Use this data to identify any problem loans you need to follow up on.
Most payments are automatically reinvested. But you may choose to transfer some payments out to reinvest elsewhere or withdraw. Just monitor the dashboard regularly like you would any investment account.
Investing well in P2P loans takes research upfront and ongoing monitoring. But it’s worth the effort for motivated investors comfortable with the risks. Follow the best practices outlined here and you’ll be on your way to adding P2P lending to your investment portfolio.
Conclusion
Investing in P2P lending provides an opportunity to earn attractive fixed-income returns by funding personal loans. However, it also comes with the risks of borrower defaults and platform failure. Do your research upfront, diversify your investments, and monitor your portfolio regularly. Used carefully, P2P lending can be a valuable addition to an investment portfolio. learn here more about Passive income growth and make money online earning ideas.