Peer-to-peer lending can offer savers an additional tool for making their money work for them. One of the attractions to peer-to-peer lending is that it requires little money to get started. At Prosper and The Lending Club, investors can start lending with as little as $25.
The concept of Peer-to-peer lending can be compared to a bank. Both act as an intermediary between savers and borrowers. Where the difference lies though is who takes on the risk. At a bank, it is the bank that takes on the risk of lending money to borrowers, while the depositors’ money is safe. In peer-to-peer lending, it is the investor who chooses which loans they will fund and it is the investor who takes on the risk. To compensate for the increased risk to the investor, peer-to-peer lending offers a much higher rate of return then a savings account offers.
The two most well-known peer-to-peer lending companies are Prosper and The Lending Club. They differ in the specifics in how they each work, however, the concept of each is the same. Borrowers fill out an application. Prosper or The Lending Club, will approve or reject the loan applications based on the criteria they have set (such as a minimum FICO score, loan amount, etc.). From there, the approved loan applications will be available to the investors. The investors pool together the amount of money that they are each individually willing to invest into any one particular loan. So for example, John Doe, a borrower, might be trying to get a $15,000 loan on Prosper. That $15,000 may be funded by 600 investors who invested $25 each into the loan.
Once you invest in a loan, you will receive principal and interest payments each month for the loan(s) that you helped to fund. The payments will be posted to your account at Prosper or The Lending Club and from there you can either use that money to invest in more loans or you can have the money transferred to your savings or checking account at your financial institution.
The advantage of investing in peer-to-peer lending are the interest rates. Average returns range anywhere between 5 – 10%. The other advantage is that the entry barrier into peer-to-peer lending is low, as the minimum amount to get started is $25.
The disadvantage to peer-to-peer lending is the default risk (the risk that the borrower will not pay back the money in full). Many investors diversify their peer-to-peer lending investments by only investing the minimum amount ($25) in each loan to minimize the affects of a loan default. If a loan does default, it will be sent to a collection agency. If attempts at collections are not successful then the loan will be charged-off and you will lose your remaining investment in the loan.
The other disadvantage in peer-to-peer lending is that it is not available in all states. The list of states that you can invest with Prosper and The Lending Club loans vary between the two. Both companies are working on expanding the number of states that investors can participate in. With the lending Club, even if investing in loans is not approved in your state, you may still be able to participate by buying Lending Club loans that have already been funded by other investors.
In Prosper’s early days, investing was available in all 50 states. During this time I tried my hand at peer-to-peer lending and was happy with the 8% return that I earned on my portfolio. Unfortunately, at this time neither Prosper or The Lending Club is open for investing in my state.
If you are considering participating in peer-to-peer lending, the important thing to keep in mind is that it is an investment and it carries the risk of default. Peoples experiences with peer-to-peer lending varies from good to bad. While the potential rate of return is attractive, my advice to peer-to-peer lenders is to only invest what you can afford to lose and to diversify the loans that you invest in.
What are some of your experiences with peer-to-peer lending?