What is P2P Lending?

As low interest rates becomes the norm, more people are turning to P2P.

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Investing in peer-to-peer (P2P) lending is a great way to boost yields and diversify your portfolio significantly. P2P lending is an alternative asset that offers attractive absolute and risk-adjusted returns, even in today's low-interest-rate environment. Like any investment offering higher than average returns, there are substantial risks, and P2P lending is no exception.

We will explain the most important issues in P2P lending and show you how you can invest in P2P.

What Are P2P Lenders?

P2P lenders are to traditional banks what Amazon is to bookstores: an electronic marketplace where all transactions are digital. On this digital platform, people who need money (borrowers) match with people who have money to invest (lenders). Reputable P2P sites include Zopa and RateSetter in the United Kingdom and LendingClub and Prosper Marketplace in the United States. And there are many others worldwide. In the U.S., P2P lenders are nonbank financial companies (NBFCs), just like investment banks, hedge funds, mortgage lenders, and private equity firms.

P2P has been around only since 2005 when U.K.-based Zopa introduced the first peer-to-peer online loan. Prosper followed this in the United States in 2006. P2P lenders combine traditional credit analysis, underwriting, and loan servicing with technology-enabled platforms. Consumers have flocked to online banking just like they have to online shopping. As a result, peer-to-peer lending in the United States is estimated at $32.2 billion in the year 2020, and $120 billion worldwide.

What Is Investing in P2P Lending?

When you invest through P2P lending, you become the bank for someone else. You create a portfolio of unsecured loans that can potentially return 7% to 11% annually. You can make loans to more than one person because P2P lending is often made in $25 increments. This allows investors to spread their investment into slivers of many loans.

If you don't want to take too much risk, you can loan only to high-rated borrowers. If you are comfortable with more risk, you can diversify your investment across many types of borrowers. You may also diversify your investment by loan type, size, term, duration, and geographic concentration. Most experts advise an 80:20 rule, with 80% of your P2P lending investment placed with high-rated borrowers and 20% with lower-rated ones. Because P2P platforms are technology-driven, P2P investors can achieve extraordinary and unprecedented loan diversification with ease.

P2P lending investments may be placed in IRAs and other retirement vehicles.

Many investors report returns of greater than 10% on their P2P lending portfolios, even after allowing for defaults and fees. However, like any investment, there is a high level of risk involved. So investment in P2P lending is suitable mostly for investors with a high-risk appetite.

Why P2P Is Popular

P2P platforms tend to provide cheaper and quicker services than traditional banks and operate with lower overhead. P2P lenders pass many of these savings onto borrowers in lower rates and fees, hence their enormous popularity. In fact, the P2P market, on average, grows more than 40% a year.

P2P is a fully recognized and legitimate form of finance and investment and is regulated by the Securities and Exchange Commission (SEC). The commission's focus is on protecting lenders (investors) through disclosure requirements. Because the SEC regards P2P lending investments as securities, these types of investments are subject to a host of rules, including Rule 415 of the Securities Act of 1933, the JOBS Act, and the blue sky laws of state securities regulations.

Today, P2P lending performs an important role in providing access to capital, especially as banks continue to retreat from consumer and small business lending, and new regulations increase the cost of capital for traditional banks.

How P2P Lending Works

It all starts when borrowers fill out a loan application and state their basic information, including:

  • Loan amount they are seeking
  • Purpose of the money
  • Payback period (loan term)
  • Borrower's income, debt, and bankruptcy history
  • Credit score
On most websites, an individual can borrow up to $35,000 without pledging collateral, so the loan is unsecured. Loans usually run from three to five years and can be used for almost any purpose: debt consolidation of credit card loans (the most common use), car loans, or large-purchase loans. P2P loans are also self-amortizing (like a mortgage) and not revolving (like a credit card). This means they have lower interest rates. Depending on the borrower's credit rating, loan rates range anywhere from about 5% to 36%.

A common misconception is that P2P platforms accept borrowers with bad credit. In fact, most U.S. platforms require a minimum credit score of 600. P2P lenders usually don't give loans to people who have recent bankruptcies, judgments, or tax liens. In light of the pandemic, some P2P lending platforms, including Zopa and LendingClub, have stopped lending to the riskiest categories of borrowers.

The Types of Loans Available in P2P Investing

On most P2P platforms, the minimum investment is $1,000. You can choose from any approved loan for investment. Each loan listing shows an interest rate, a credit grade, and a payback period (“term”), usually three to five years.

The P2P platform administers all aspects of the loans, from underwriting to collecting monthly installments. The platform then sends you your portion of the payments, minus the fees charged by the website (typically 1%). Investors take only two actions: Select loans and collect payments.

Technically speaking, investors do not make loans directly to borrowers. Once an investor chooses to fund a loan, a separate bank issues the loan to the borrower and then sells the loan to the P2P platform. The platform then issues a separate note to the investor with a return on the investment contingent upon the borrower repaying the original loan.

So, the investor has made an investment in a note, not an actual loan, and hopes that the borrower will repay so that the note will be paid by the platform. If this seems elaborate to you, it is what is known in the law as a “workaround,” the legal means by which P2P lending investments are able to comply with SEC regulations and most state securities laws (Iowa is an exception.)

What Are the Main Risks of P2P Investing?

As we mentioned before, investing in P2P lending is risky. Here are some of the main risks of P2P:

1. Higher Chance of Defaults

The biggest risk to investors is that borrowers do not pay back their loans. The second risk is that the platform itself goes bust. If a borrower defaults, especially early in the loan term, you might lose your investment. But if the platform goes out of business, investors lose all their money. You will not be reimbursed by any government insurance programs, (e.g., the FDIC).

What happens when a borrower doesn't repay their loan? Most likely, the P2P platform will sell the defaulted loan to a third-party collection service at a fraction of its original amount (usually 3% to 5%), effectively wiping out the value of the loan. Investors should not rely on the platform to pursue borrowers in the courts; they generally don't bother.

2. Platform Reliance on Stated vs. Verified Income

Until the pandemic, P2P platforms did not verify all borrowers' information, though now, LendingClub reports 90% verification rates on new borrowers. Platforms also do not accept responsibility for making credit decisions. For example, the fine print in LendingClub's documentation ambiguously states:

(1) Member loans are made without obtaining any documentation of the borrower applicant's ability to afford the loan.

and

(2) Although we perform income verification, the platform's underwriting, credit, and pricing decisioning may be based on stated borrower income, rather than the verified income.

This is a situation that is ripe for abuse and stated versus verified income caused many troubles during the 2008 financial crisis—so select loans with verified incomes to reduce your risk exposure.

3. Illiquidity

Your money is invested for the term of the loan, though each monthly payment returns some principal and some interest. If a borrower makes late payments, you are “on the hook” until the borrower repays. Investors wishing to unwind their positions early may be able to sell their loans at substantial discounts on the secondary market, if at all. P2P investments require a “buy and hold” strategy and are illiquid.

>>Further Reading: How to Invest Your Money

What are the Main Rewards of P2P Investing?

Like any investment, there are also advantages to investing in P2P:

1. High Yields

Just like in high yield investing, the high yields of P2P loans have more than offset historical default rates and platform fees. In fact, according to a newly issued report by Morgan Stanley, the yields on P2P loans yield “outsized credit spreads” and they “may provide a cushion against realized principal loss when investors encounter adverse economic environments, such as those caused by the COVID-19 pandemic or experienced during the global financial crisis.” Basically, this means that the yields are high enough to justify some investment.

2. Unprecedented Ability to Diversify

Successful P2P lending investment during the global pandemic requires choosing carefully and diversifying strongly. One of the most powerful advantages of P2P lending is the ability to invest in portions, or “slivers,” of many loans. These slivers can be as little as $25. An investment of $1,000 can be spread over 40 loans, diversifying your investment without raising costs, and reducing your exposure to defaults.

3. Portfolio Diversification

P2P lending is a great way to diversify your portfolio with alternative investments that are, in large part, uncorrelated to movements in traditional stock and fixed income markets. So adding some P2P lending to your investments will let you balance your overall portfolio. Fans of modern portfolio theory will recognize that blending some P2P lending into a diverse portfolio of fixed-income investments captures the “efficient” parts of the risk-reward spectrum. With global markets becoming more volatile each day, alternative investments are important tools for achieving steady and attractive returns.

How to Balance the Risks of P2P Investing

Let's compare a hypothetical $10,000 investment for three years in two different fixed income portfolios:

  • Portfolio A: a traditional fixed income portfolio, and
  • Portfolio B: a traditional fixed income portfolio with a P2P investment

The first portfolio places $5,000 in three-year U.S. Treasuries (“govies”) at 0.18% and $5,000 in a 36 month bank CD at 1.0%. Over three years, the “govie” will earn $27 ( 0.18% x $5,000 x 3 years) and the CD will earn $150. So Portfolio A will earn $177 in total, or a 0.59% annual return, without compounding. Keep in mind that both govies and CDs are liquid investments.

In Portfolio B, $1,000 of that $10,000 portfolio is placed into a well-diversified P2P lending investment yielding 10% after fees.

Let's project that 10% of this $1,000 ends in defaults, wiping out $100 of your investment. You still have $900 of P2P loans remaining that are earning 10% per year. So in three years, you'll earn $270. Your original $1,000 investment is now $1,170. Keep in mind this part of the portfolio was illiquid though paying monthly.

The $9,000 balance you had in government securities ($4,500 at 0.18%) and bank CDs ($4,500 at 1%) will earn $159.30 in the same period. So Portfolio B's combined return over the three years is $170 from P2P plus $159.30 from govies and bank CDs, totaling $329.30, which is 86% greater than Portfolio A's $177.

This Blending Brings Profit With Low Risk

Basically, the safest way to play is to blend in a small slice of P2P lending into your fixed-income portfolio. If you went with Portfolio B, you raised your total return from $177 to $329.30, and your annual return from 0.59% to 1.10%.

Fixed Income Portfolio A
$10,000 divided as follows:
Fixed Income Portfolio B
$10,000 divided as follows:
$5,000 in three-year Treasury at 0.18%
$5,000 in bank CD at 1%
$ 4,500 in three-year Treasury at 0.18%
$ 4,500 in bank CD at 1%
$ 1,000 in P2P at 10% with 10% default rate
Three-year cash return: $177 or 0.59% Three-year cash return: $329.30 or 1.10%

Is P2P Investing a Good Idea?

Investing in P2P lending by itself is too risky without other securities to diversify your portfolio. But P2P can significantly raise returns on fixed income portfolios if you allocate no more than 10% as part of a diversification strategy. Don't be intimidated by loan selection: easy-to-use portfolio managing software, like NSR Invest, plugs into your chosen P2P platform and can help you choose, assemble, and manage a diversified portfolio. Add P2P lending to your portfolio like you add salt to food: too much ruins the taste; too little and the flavor is lost. Modest amounts yield optimum results.

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