Thanks to an internet phenomenon that has become known as “crowd lending”, long gone are the days when you had to go to a bank to get the money you needed for your small personal loans. All one has to do now is go online, create a profile, and wait for other people to fund it.
However, the excitement doesn’t end there. Not only are peer to peer sites a great place for borrowers to find the best personal loans, they can also be an extraordinary way for savvy investors to create multiple steady streams of passive income, or quickly find $2,200 in emergency cash.
Here is look into the world of peer to peer (P2P) lending works and how this can be a money-making opportunity for you.
How P2P Lending Works:
Asking for Small Personal Loans:
P2P lending starts when a person needs a loan for something and they want an alternative to going to the bank for a traditional, conventional loan.
The loan can be for anything: A new business, getting out of debt, a new construction, etc. Once this person signs up to a peer to peer site and asks for a loan, they become a “borrower”.
On the other side of things are the “investors”. The investor basically acts as a bank. They will sponsor the loans with their own personal money (as if they were a bank).
Once the money is lent, the borrower must pay back the investors within a specific amount of time and at a set interest rate (more on this below).
The P2P site makes its money by taking a small percentage of the interest on each loan. This is their fee for brokering the transaction.
Rate of Return on Investment:
Like we mentioned, each loan will carry a set amount of interest that will be charged (just like a loan from the bank would).
The interest rate of the loan will largely depend on the borrower’s credit rating. As you might guess:
- Borrowers with great credit will pay the lowest interest rates (say around 6%).
- As a borrower’s credit becomes worse, the interest rate they must pay becomes higher (sometimes over 30%).
It’s the magnitude of these interest rates that really attract investors. Because they are so significantly higher than that of CD’s and bonds, investors will risk sponsoring such loans optimistically hoping they can capture a slice of these returns.
Since its inception, peer to peer investing has often been quoted as producing anywhere between 5 and 12% returns! When you compare that figure to the 10% average growth rate of stocks, P2P investing doesn’t come across as a bad return on investment.
These scheduled payments of interest and principal have been hailed by many passive income enthusiasts as a wonderful alternative to traditional forms of investing. For example, while stock market returns may fluctuate day to day, p2p loans will on average provide consistent and steady returns.
Reducing Risk By Diversifying Borrowers:
As is the case with any loan, there is the risk that the borrower could default. This would mean that they fail to pay back the principal and interest that they owe.
When this happens, usually the P2P site will send the borrower to claims to try to recoup the money that is owed. However because this personal loan is unsecured, it is often the case that the money is simply lost.
This is why it is very important for an investor to pay attention to the credit rating of the borrower. Even though the borrowers with good credit produce the lowest returns, then do have the highest probability of paying back their loans in full. Investors with poor credit have the highest chance of failing to meet the obligations of their loans.
One strategy to combat this situation that has developed over the years is to diversify the number of investments you make.
For example, typically if a borrower needs $10,000, they will not receive the entire $10,000 from just one investor. The money for that loan will come from many investors in the form of $25, $50, and even $100 increments (called notes). By spreading their notes across many different borrowers, P2P investors can minimize the risk of default.
The Top Peer to Peer Lending Sites:
Currently the top two P2P lending sites are Prosper and Lending Club.
Prosper was the first site in 2006 and has been responsible for brokering over $3 billion dollars in small personal loans.
Lending Club has been around since 2007 and issued over $9 billion dollars in loans. Both sites are very similar in the way they function and have specific rates of interest as well as loan amounts that they offer for borrowers.
It is very important to note that not all places in the US and worldwide allow borrowing and/or lending from peer to peer sites.
Before you engage in either P2P lending or borrowing, make sure you understand if your local laws allows it.