What Is Peer-to-Peer Lending? Here’s How It Works and What You Should Know
You have a little money saved up. Nice. But it’s just sitting in a bank account earning between 1 and 2% interest. At that rate, your money is going to grow at a snail’s pace. You know you could invest in the stock market, but what if it crashes?
If you’re looking for a way to invest your money that gives you a good amount of control over the risk and you can make more than you would by keeping your money in the bank, then peer-to-peer lending (P2P) is worth a look.
What Is Peer-to-Peer Lending?
P2P lending is a system that matches people who need loans with private investors who are willing to lend money. No banks needed. (You may also hear it referred to as “crowdfunding.”) Loans can be for anything from debt consolidation to payday loans or even small business loans.
To become an investor in P2P lending, you would first set up an account with a P2P website. You’ll likely be required to make a minimum deposit of at least $1,000. You don’t have to invest all of it at once, but you need to have that much money available. The reason for the $1,000 minimum is that you’ll use it to invest in multiple loan notes, thus diversifying your money. This minimizes your risk.
Once you sign up, you can choose your investments. Would you rather earn a smaller return (6% or lower) on low-risk loans, or would you prefer to go for big returns (10% and above) with high-risk loans? As with a bank, the lending platform determines loan risk by credit scores, employment, and other borrower traits.
You don’t have to go it alone, either. You can open a joint account with your spouse or other investors who share your investment goals.
Who Can Invest in P2P Lending?
Here’s where it gets tricky: Peer-to-peer lending isn’t open to everyone.
The U.S. Securities and Exchange Commission (SEC) has determined that even if banks aren’t involved, some rules do need to be in place to govern crowdfunding for investors.
Here are the basic restrictions to investing in P2P lending:
If either your annual income or your net worth is less than $107,000 during any 12-month period:
- You can invest up to $2,200.
- You can invest up to 5% of your annual income or net worth (whichever is less).
If both your annual income and your net worth are $107,000 or more during any 12-month period:
- You can invest up to 10% of your annual income or your net worth (whichever is less).
- No matter what your annual income or net worth, you can’t invest more than $107,000.
In other words, you can’t invest your whole nest egg at once. But, even if you’re only making $30,000 per year, you can still invest up to $2,200 annually. If you don’t know your net worth, use a net worth calculator to figure it out.
Investors must also use a peer-to-peer lending platform that is registered with the SEC and is a member of the Financial Industry Regulatory Authority (FINRA). You must use an approved website or app as a broker. That means no company can come to you directly to solicit investments.
The SEC also cautions investors to understand the risks of P2P lending. These loans inherently come with risk, so you should only invest money that you can afford to lose.
Pros and Cons of Investing in P2P Lending
P2P lending has only been around since 2005, and it’s still gaining traction with both borrowers and investors. For that reason, some of the pros and cons are still being discovered. However, we do know a few things:
- It’s relatively fast and easy to set up your account and get started.
- The transactions are all done online or on your phone. No awkward trips to a bank or meeting borrowers first-hand.
- Investors can get a much higher return for their money than they would by keeping it in a bank or investing in a long-term certificate of deposit.
- You can choose your level of risk/reward.
- Some sites let you invest as little as $25 per loan. You don’t have to fund an entire loan, thus minimizing your risk in case of default.
- You’ll receive monthly payments of principal plus interest as the loans are paid off.
- Many of these loans are used for debt consolidation, which means they are inherently higher risk than some other types of loans.
- These platforms are not FDIC-insured the way banks are, so if a borrower defaults on their loan, no one is paying back your money.
- It’s still a young industry, which means we don’t yet know how it will respond to a market crash or an economic downturn.
- Once you’ve loaned the money, you’re in it for the long haul. There are no secondary markets where you can sell off your loans to get out. That may change in the near future, but for now, you have to assume your money will be tied up in that loan until it is paid back.
- Your investment earns diminishing returns. You’ll earn less and less interest as the loan is paid back. You’ll need to reinvest it if you want to continue earning interest with it.
5 of the Best P2P Lending Websites for Investors
New broker sites and apps are popping up all the time, but these five are consistently listed among the best in the business. You may want to start out with one of these tried-and-true P2P sites.
The first P2P company to become publicly traded, Lending Club is the big dog on the market. You need $1,000 to get started, but you have the option of going solo or with a joint account. You can lend as little as $25 per loan, so you can diversify your money and protect yourself from default loans.
You can also automate your lending portfolio based on your risk preferences so you don’t have to hand-pick which borrowers are right for you.
Upstart boasts that they look at more than just credit scores when evaluating borrowers, so if you’re looking for a site that is trying to help the little guy, Upstart could be your jam. Of course, that means that some of the loans carry a higher risk, but that also means the potential for higher returns.
Another of Upstart’s perks is the investor’s ability to open an IRA. That comes with some tax benefits for your investments.
Prosper is the original peer-to-peer lending site. Started in 2005, it was the first one to hit the market and it’s still going strong today. Prosper has a user-friendly phone app to keep on top of your investments.
One major perk of Prosper is that you can get started with just $25. However, Prosper suggests that you invest $2,500 – 100 x $25 notes – to have your money properly diversified.
If you are looking to get into the P2P investing market but don’t know where to start, you may want to check out Peerform. Peerform allows you to diversify using 16 categories. You also have the option to take on a full loan rather than just a fraction of a loan, if that sounds attractive to you.
Peerform requires you to be an “accredited investor” to take part, so read up on their rules before trying to jump in.
If you have a passion for small business, Funding Circle is your stop. The platform’s owners tried to get funding for their own small business but were shot down repeatedly. By “repeatedly,” we mean 96 times. So, they decided to create a solution that would connect small business owners in the U.S. and UK with investors.
No bad debt consolidation loans here. While Funding Circle does require $50,000 to open your account, you can invest as little as $500 at a time.
Tyler Omoth is a freelance writer covering topics from personal finance to career advice and even lawn care. His work has been featured on TopResume.com, Writersweekly.com and more. He is also the author of over 70 educational books for children and a proud parent of twin toddlers.