Investing in Peer to Peer Lending

Investing in Peer to Peer Lending

Investing in Peer to Peer Lending

Diversifying your portfolio is a crucial aspect to growth. This means combining investments that offer safe, secure rates that tend to be lower with opportunities to earn higher returns that also increase the risk. Peer to peer lending offers the potential for higher returns with the caveat that there is greater risk attached to the investment.

Sometimes called marketplace lending, peer to peer allows you to lend money directly to borrowers. Instead of using a financial institution such as a bank or lending firm, you provide the cash needed to a borrower looking to start up a business, expand a profitable venture, or other activity that promises considerable returns.

Many peer to peer lending practices involve not just small business, but real estate and even student loans. The profit potential is considerable since the return rates are often double digits, but the risk is amplified as well.

Why is Investing in Peer to Peer Lending so Popular?

This form of lending has been around as long, if not longer than traditional lending institutions. A person or group of wealthy people loaning money with the intent on receiving a return may be as old as money itself. But over the past few centuries such practices were downplayed because of the risk and the popularity of lending institutions for those who wanted to build businesses, purchase real estate, or get loans to improve their own status.

That changed dramatically with the housing collapse of 2008 when traditional lenders changed their lending practices. It became harder to get a traditional loan as a result. When combined with the rise of crowdfunding a few years later, peer to peer lending suddenly became popular once again.

Advantages of Investing in Peer to Peer Lending

There are considerable benefits to investing in peer to peer lending. For many who are trying to expand their portfolios, this form of investing in peer to peer lending offers considerable opportunities.

  • Direction: There are different types of peer to peer lending situations ranging from business loans to real estate investment to student loans and more. You can choose which type to invest and start with lower-risk ventures until you become more comfortable with the practice. In addition, you can join investing groups that specialize in this form of lending.
  • Diversification: You can gain access to different types of lending which, despite the higher individual risk, reduces the overall risk to your portfolio. This is because you can spread out your investments across a wider range that helps garner better overall returns. This is known as purchasing notes, where you offer a limited amount of money, usually combined with notes from other investors, which means you put less into the original investment.
  • Type of Loan: The loans created through peer to peer lending generally perform better compared to traditional investments. It’s common to see investment returns reaching double digits, although arguably most fall within the 5% to 9% return rate. Even at that lower rate, peer to peer lending outperforms many traditional types of investing.

Disadvantages of Investing in Peer to Peer Lending

With greater rewards comes greater risks. Peer to peer lending is no different in this regard. Before you decide to use this form of investment, it pays to understand the risks that are involved.

  • Unsecured Loans: Because the loans are being made to individuals, the risk that the loans will default is considerably higher compared to lending that involves collateral. While real estate investments at least have the collateral of the land itself, it is possible to lose all the money invested if the loan defaults based on a failed business or individual that does not carry through with their promise.
  • You can mitigate the risk to a certain extent by diversifying across many different notes rather than putting all your eggs in one basket. However, there will still be loans that default, so you should be prepared for that eventuality.
  • Depletion: The loans involved in peer to peer lending are being paid off over time. This means that your investment will eventually get to zero at some point with a successful loan. Unless you reinvest the payments into another area, you will not have any investment capital when the loan is completed. In other words, you cannot just spend from the money being made back from the loan like you would with bonds for example and expect the money to continue coming in.
  • Lack of FDIC Insurance: This form of investment is not covered by the FDIC. So, if the borrower defaults, you will not be reimbursed for the loan. This is also true if the platformed used for the peer to peer investment fails as well. However, in such cases another institution will usually buy out and take over the failed platform, but it does not happen all the time.
  • Liquidity: It’s possible to sell the notes that you have obtained through this form of lending, but the liquidity is limited. Plus, sales of notes are made for less than your original investment, so you stand to lose money in the process. If you need to cash out your note for whatever reason, then you should expect to take a loss on the investment. This limits the liquidity of this type of lending practice.

Because this type of lending is relatively new, at least it has not been practiced in this widespread manner until recently, the longevity of the platform is still unknown. In other words, peer to peer lending may become even more popular and viable over the years or it may falter and crash.

But even with all the negatives associated with peer to peer lending, it is considered today a strong, viable form of investing. You will need to be careful, especially at first when you have limited knowledge and experience. Purchasing small notes for as little as $25 instead of making large scale investments is a great way to lower the risk while still earning a healthy return.

While the future may be uncertain with peer to peer lending, it is a strong, viable form of investment that you can take advantage of today.

 

Investing in Peer to Peer Lending, ©Sophisticated Investor 2021