Over the past few years, there’s been considerable interest in fintech lending as an alternative funding source for consumers and small and medium-sized enterprises. According to Paypers, the global fintech lending industry has been growing by 17 percent every year and is expected to reach $312.6 billion in value in 2020. Peer-to-peer (P2P) lending is one of the fastest-growing fintech business models and has since become a key area of interest for investors in recent years.
This is a relatively new type of investment that makes it easy for consumers and businesses to secure financing and allows individual or corporate investors to diversify their portfolios and make higher returns. Here’s what you need to know about P2P lending, how it works, and how you can invest as a P2P lender:
What is Peer-to-Peer Lending?
Consider how commercial banks make money: customers deposit their money with the bank and earn a small interest rate. The bank then lends the money out to businesses and consumers at much higher interest rates. P2P lending works differently in the sense that consumers or businesses borrow money directly from an individual or a group of individuals (investors) without using a bank, credit union, or any other financial institution as an intermediary.
Everything is done through an online lending market platform that connects potential borrowers to investors/lenders. The purpose of P2P lending is to cut off the financial institution as an intermediary, making it easier for people who can’t or don’t want to source financing from a traditional lender to borrow from investors.
How Peer-to-Peer Investing Work?
Unlike traditional lenders, P2P lending platforms work with investors who fund consumer and business loans. And since there’s no “middleman” financial institution, borrowers get to enjoy lower interest rates and investors earn a decent return on their investment capital.
To obtain a P2P loan, a borrower fills out an application, reviews the interest rate they’ll be charged if they’re approved, and then waits for investors to review their profile and decide whether to fund it. Borrowers are usually required to provide basic information including:
- Credit score
- Salary/revenue and profits
- Debt-to-income ratio
- Purpose of the loan
- Loan amount
- Loan term
Investors are allowed to choose the loans they want to invest in based on the information that’s been made available to them. This makes the approval process with P2P lending platforms more flexible compared to traditional lenders.
Once the investors successfully fund a loan, the borrower receives their money and moves on to the repayment stage. The borrower will then make regular payments which will be split up among the various investors/lenders, each getting a proportional share.
As an investor, you don’t have to invest all your investment capital in whole loans. Instead, you can invest in tiny slivers or parts of loans (notes) in denominations as low as $50. This will reduce the risk of losing your entire investment capital in a single loan default as you’ll have spread it out across many different notes.
How Do You Become an Investor?
The requirements differ depending on the online lending platform you choose to invest through as well as where you live. However, you don’t have to be a millionaire to start investing in P2P lending, but you should envision yourself achieving that goal. If you want to become an investor, here’s what you need to do:
- Create an account and set up your online profile on a P2P lending website of your choice.
- Take the time to review loan options and fill out your investment portfolio. You’ll need to purchase different kinds of notes before you begin investing.
- Keep tabs on your earnings as borrowers pay off their loans.
Keep in mind that the P2P lending website handles all the administrative tasks including underwriting loan applications, closing loan applications, collecting monthly payments from borrowers, and distributing loan proceeds. The only thing you’re left with as an investor is to select which loans to fund and then wait to collect repayments on each loan you invested in.
It’s important that you take the time to review the terms and conditions of the P2P lending platform you choose before investing your dollars. Most platforms charge a 1% management fee on the monthly payments remitted to the investors on each loan.
Is Peer-to-Peer Investing a Good Idea?
If you’re looking to add some diversity to your investment portfolio or want to generate a decent passive income, investing in P2P lending might be worth consideration. The benefits of P2P investing include high rates of return and the ability to build your own portfolio. P2P lending platforms offer interest rates ranging from 6 percent to 25 percent or more. Investor returns usually range from 2 percent to 10 percent depending on how much money you invest and for how long. Investors who blend credit grades in their investment portfolio earn returns of greater than 10 percent.
As an investor, you have more control over the variables surrounding their specific investments in your portfolio. As with any investment, there are risks that come with P2P lending. Some of the risks involved include lack of FDIC insurance coverage on your investment and a greater likelihood of default since P2P loans are unsecured. You can get the most out of P2P investing by diversifying your holdings across different notes, funding profiles with lower debt-to-income ratios, and choosing borrowers with greater employment stability and higher credit scores.