A definitive guide to peer-to-peer lending platforms
Peer-to-peer lending platforms have become very popular in recent years. It’s continued to grow since the financial crisis of 2008. And this is due, on the one hand, to the fact that it is an investment modality that allows investors to get a great return on their money.
On the other hand, it has become a prevalent form of financing among individuals and small companies. However, despite this popularity, some investors are still not sure whether to put their money into this kind of investment. And some borrowers still look at the bank as the only institution that lends money. That means many still need to learn what peer-to-peer lending is and how it works. This article seeks to shed more light on this system.
To know what peer-to-peer lending is and how it works, we’ve prepared this guide to help you understand how to invest in or get funding on a peer-to-peer lending platform. We’ll also see the criteria to identify a good P2P lending platform and what the best ones are.
What is a peer-to-peer lending platform?
First, peer-to-peer (P2P) lending is also called P2P lending for short or white-label peer-to-peer lending. It is a financial system where lenders give loans directly to borrowers who meet the loan terms, like the minimum credit score and agree to the prepayment penalties set by the facilitator, which is the lending platform.
In other words, unlike traditional banking institutions, peer-to-peer lending platforms are online marketplaces created for individuals and businesses to lend and borrow money from each other.
A peer-to-peer platform acts as the middleman and regulator, handling the process of loan origination, underwriting, loan approval, and servicing.
However, it does not provide the actual funds for the loan.
Peer-to-peer lending marketplaces provide an investment opportunity in which someone who has money lends it to someone who needs it in exchange for interest and a promise to repay the principal fee plus the origination fee.
Peer-to-peer loan platforms are dedicated to putting investors, that is, peer-to-peer lenders, in contact with individuals and companies that require money, in other words, borrowers.
The primary purposes of peer-to-peer loans are:
- Buy a car
- Finance invoices
- Personal loans
- Business loans for expansion
- Short term loans
- Agricultural loans
Like DeFi lending platforms, peer-to-peer platforms are great alternatives to the traditional financial system. With them, peer-to-peer lenders can lend their money, and borrowers can borrow money without involving a traditional financial institution such as a bank, credit union, or other conventional lenders.
By removing traditional financial institutions from the equation, on the one hand, P2P lenders get more competitive interest rates than they would if they made a deposit in a bank or opened a savings account.
On the other hand, the fact that there are no traditional financial institutions involved in the process makes it possible for people who might not have access to fair credit not only to have the opportunity to obtain money but also to access lower interest rates than the interest rates they would get with a conventional loan.
It must be considered that peer-to-peer lending does not involve saving money at higher interest rates than what you get with traditional bank loans or credit unions. Instead, it is an investment with a risk of losing part or all of the capital invested.
But don’t be too scared by this. As we will see later, some strategies can be used to reduce the risk of losing money significantly.
How do peer-to-peer lending platforms operate?
A P2P lending platform works like a P2P exchange.
It all starts when a person or company that needs money requests a loan from one of the peer-to-peer loan platforms or to one of the associated companies, also known as loan originators.
Every time a peer-to-peer lending platform receives a loan application, it analyzes it and then assigns it a risk profile. During this process, all available data and documents are reviewed to assess the ability of each individual or company to repay the loan.
It lets the platform and investors know the risk of lending to each applicant in detail. In other words, assigning a return/profitability to each approved loan is possible.
When all the information is ready, the peer-to-peer lending platform publishes the loan on its website so registered peer-to-peer lenders can evaluate and decide if the loan suits their investment needs.
If this happens and the loan is within the risk aversion margin, the interested investors will contribute the necessary capital to finance this loan.
Finally, the peer-to-peer lending platform will collect all the investments and give the money to the loan applicant.
From here, the borrower will have to repay the loan and the interest to the peer-to-peer lending platform, which will distribute them to investors after deducting their commissions.
Why invest in peer-to-peer lending?
- Initial investment: Most peer-to-peer loan platforms have very low initial investment requirements. With many of them, you can start investing with as little as $10. In addition, it makes peer-to-peer lending accessible to all types of investors.
- Diversification: It is effortless to open several accounts on different platforms and, in each of them, distribute your money among many types of peer-to-peer loans, thus diversifying and reducing risk.
- Investment term: You can invest in loans of different durations. This characteristic makes it fit any investment time horizon, whether for a month or a few years.
- Simplicity: It is effortless to open an account. You must choose what kind of peer-to-peer loans you want your money to be invested in. Then the platform will automatically select all the loans that meet your specifications.
- Stock market independent: Since peer-to-peer lending is an entirely different type of investment than stocks, it is not impacted by what happens in the stock markets. They do not correlate.
- Ease of reinvestment: You can automatically reinvest your earnings, earning interest on interest and benefiting from the power of compound interest.
- Commissions: Peer-to-peer loan platforms take low commissions. And these are generally paid by borrowers.
- Returns: It is not very difficult to get returns on your capital above 10% when you invest in peer-to-peer loan platforms
Keep reading if you want to know the disadvantages of investing in peer-to-peer platforms.
What are the risks of peer-to-peer lending?
By now, you’re already thinking about peer-to-peer lending. But like anything in life, it can’t just be about advantages. Well, you are right. Peer-to-peer lending has some risks that you need to be aware of before you start investing.
- Little regulation: Peer-to-peer lending is relatively new. So, there are few rules or regulations.
- Liquidity: It can be difficult to recover your money quickly on some smaller platforms that do not have a secondary market where you can sell the loans to convert them into cash.
- Bankruptcy: The peer-to-peer lending platform or the company that gives the loans can go bankrupt. In this case, you may lose part or all of your money if there is no mechanism for the peer-to-peer loans to continue to be paid.
- Lack of loans: Your money may only be invested in peer-to-peer loans if there are loan requests. But this will depend on the platform. If not enough borrowers are available, part of your money may remain in the account and not be invested. In this case, no return is generated, and this is what is known as “Cash Drag.”
- Too much variety: There are so many different types of platforms which makes investing in peer-to-peer lending sometimes become a complex process.
- Non-payment: the borrower may pay late, and you receive the money late, or they may not pay at all, and you lose your money. Peer-to-peer lending marketplaces don’t take collaterals. Borrowers only need to meet the minimum credit score requirements. That is why you must invest in platforms with a buyback guarantee allowing you to recover your money.
What to consider while choosing a peer-to-peer platform
We have tested various providers so that you can find the right platform for you. And so that we get meaningful results, we defined seven test criteria in advance. Then, we examined which platform meets the relevant criteria to what extent and were thus able to identify the strengths and weaknesses of the individual P2P providers.
The number of available P2P credits
The number of peer-to-peer loans offered differs from platform to platform but is mainly responsible for whether an investment is successful in the long term or not. The reason is straightforward: the more loans are offered, the easier it is to diversify the total investment amount, i.e., to spread it. Moreover, if there are problems with a loan, for example, because there is a risk of default, the other loans will compensate for a possible default with their returns.
Minimum investment amount
It plays a significant role not only for newcomers to investing in P2P lending but also for more experienced investors. The lower the minimum investment amount, the more opportunities you have to spread your risk. This point also has a positive effect on your diversification.
Fees significantly impact your returns when investing in P2P lending, so all other things being equal, you should always choose the platform with the lower fees.
If you first want to find out whether investing in P2P lending suits you, you should first go through the possible registration process so you can get started immediately.
If you don’t know whether P2P is the suitable investment form, you should prefer a platform that makes registration as unbureaucratic as possible.
Some providers offer a so-called buyback guarantee if borrowers don’t pay their loan installments for a certain period.
The P2P provider then buys back loans that offer a buyback guarantee if the borrower is in arrears with their monthly payments for a predetermined time, for example, 30 days.
In this case, you will get your investment in this loan back from the provider. In most cases, you will even get back the interest that would have accrued during this period.
It is a desirable risk reduction option you should watch out for in a platform.
Auto invest and portfolio builder function
All tested platforms offer this feature and can save a lot of time. Then, based on predefined criteria, the auto-investor automatically invests an investment amount they specify in P2P loans that meet their criteria.
This function is efficient and time-saving if you want to avoid selecting each loan manually.
You must provide the auto-investor with your risk-opportunity profile. But, of course, more options allow better control of the investment.
On the secondary market, you can put loans you’ve already invested in for sale or buy peer-to-peer loans from other investors.
Selling your loans makes sense, for example, if the loan has a long term and you want to liquidate it early, i.e., want to get money. In this case, you do not have to wait for the end of the term but can sell the loan to another peer-to-peer lender early.
Best peer-to-peer loan platforms
Lending Club was founded in 2007. It is a veteran P2P platform that has become one of the largest in the world. It has more than $20,000 billion in loan issuance. And this is possible because it offers loans to consumers and SMEs with repayment terms ranging from 36 to 60 months.
The growth of Lending Club has been exponential since it was created, and it currently already has 45% of the total market.
In the event of bankruptcy, they have implemented a backup system through which an intermediary company would take control and continue to lead all the operations that have occurred.
Lending Club uses the WebBank of Utah as an intermediary. When a loan has been financed, the money is released by the associated bank. Then investors are paid their interest, and the capital is returned to them according to the repayment terms agreed upon with the developer requesting financing; that is, the investors participate in the loan.
Lending Club offers loans ranging from $1,000 to $35,000 for individuals and enterprises who need small business loans. It also offers businesses and companies loans from $15,000 to $300,000.
Lending Club charges investors a fee of 1% of the loan repayments received from the borrower within 15 days of the due date. Then the borrower pays between 1 and 5% depending on their credit history or credit score. Lending Club classifies borrowers and gives them a rating.
Prosper was founded in 2006. It was the first P2P platform in the United States. It has financed over 6,000 million dollars in loans through Crowdlending, offering only consumer loans. It already has more than 1.5 million customers.
Prosper, like Lending Club, offers loans with repayment terms varying between 30 to 60 months and a loan amount ranging from $2,000 to $35,000. It uses the same method as Lending Club through the Utah WebBank, which acts as an intermediary. In addition, prosper personal loans are offered with interest rates that vary according to the borrower’s credit score or credit history.
Upstart was founded in 2014 by a group of ex-Google employees. And in all this time, it has already originated more than 300 million dollars in loans.
More than 90% of the borrowers here are university graduates. Upstart is committed to SMEs offering loans worth 3,000 and 35,000 dollars. It has three to five years of repayment, with interest rates ranging from 4 to 26%, depending on the borrower’s solvency level.
Upstart employs a model that serves it very well in avoiding defaults.
In Upstart, investors pay no fees. Instead, the company raises its funds to operate through the fees it charges the borrower. And if the borrower defaults, then Upstart reimburses the investors for their capital, and Upstart loses on the deal. The minimum investment is 100 dollars.
Funding Circle was founded in Great Britain, and 2013 it was already operating in the US. The company only makes loans through Crowdlending to SMEs and businesses. It works in the United States, the United Kingdom, Germany, and the Netherlands.
Funding Circle has originated more than $3 billion in personal and business loans. It offers a loan amount ranging from $25,000 to $500,000 with interest rates varying from 5.5 to 27.8%, depending on each borrower’s credit history, creditworthiness, or credit scores.
Investors are charged a 1% fee on all monthly payments received and must have a minimum investment starting at $50,000.
What returns can you expect?
Each platform has different returns on investment types, depending on the risk you are willing to take. Some platforms specialize in a specific type of return and risk, and others have all kinds of options.
Peer-to-peer loan platforms and the personal and business loans available to invest in could be classified into three categories according to their return/risk.
- Low risk = returns less than 10%
- Medium risk = returns between 10% and 15%
- High risk = returns more significant than 15%
For example, let’s say we invest in a medium-risk platform where we get a 12.5% return on our investment. Then that means that if we invest $10,000, we will receive a profit of $1,250 per year. That’s not bad at all.
If we take advantage of compound interest and leave our money and profits from the first year invested for a second year, we would get $12,656 in total. In other words, a benefit in the second year of $1,406.
As you can see, the benefit in the second year is 156 dollars higher than what we obtained in the first year. It is what is known as the magic of compound interest.
Peer-to-peer marketplace lending is a great investment opportunity for lenders and an easier way for borrowers to get funding. However, unlike banks, credit unions, and other traditional lenders, P2P credit providers do not have deposit insurance. As a result, some borrowers may not repay some loans. So, the money invested will be lost. Moreover, even the buyback guarantees of some providers cannot provide complete protection since the guarantor can also go bankrupt.
That’s why you have to be careful when choosing a lending platform to invest in. We see that Lending Club offers excellent returns. But we also see that Prosper is the one that provides the most security because it has the lowest default rate. However, Upstart and Funding Circle also offer good returns of up to two digits.
If you decide to invest in P2P lending, we recommend only investing a small part (max. 5%) of your assets in such a risky asset class.