What is peer-to-peer (P2P) lending? Essentially it is the process of borrowing and lending to and from peers.
P2P as a borrower
As a borrower you can go to a P2P site and request a loan. The site organizer will ask for information, including the reason that you are requesting the loan. They will also perform a bit of a credit check to give you a borrower rating – higher ratings mean lower rates.
The different types of loans I’ve seen include car financing, debt consolidation, home improvement, starting up a new business, medical procedures, and many others. I don’t believe the organizers themselves care too much about the type of loan, but the lenders (see below) do have the ability to search for specific types of loans and lend toward the reasons that interest them most.
By the way, this is just an explanation, I’m not recommending going here to borrow money. We would prefer to see you operate on a debt-free model which has been shown to greatly enhance financial fitness.
P2P as a lender
Here is the part that I find interesting: Since this is a peer-to-peer situation, the borrowers are getting money from other people – not banks or some commercial organization. So this means in the background there are people who are willing to lend money toward the different borrower requests of other people in the network.
A quick note on lending money like this before someone comments “neither a lender nor a borrower be”. An investment bond is nothing more than lending money to a corporation. So unless you are totally against bonds (and there are reasons to consider this stance) then you shouldn’t have much of a philosophical concern with lending to another person. Personally I like the idea of helping out a real person more than the idea of lending money to a big corporation (or public utility or whatever bond is available to you).
As a lender in a P2P network you deposit a certain amount of money that you would like to invest. You then decide what loans you want to support. An interesting factor in this mix is that you are forced into a diversification model by investing to cover only a portion of someone’s loan. So, for example, if someone wants to borrow $500 what will happen is twenty different investors will lend $25 each. Your portfolio of loans winds up consisting of many loans of $25 each to many different people, with different credit ratings (if you want), who are borrowing for different purposes. Because of this model your risk is greatly reduced. A default by one person will have a minimal impact on your overall returns.
To better explain this, I’ll talk a bit about our personal experience with Prosper…
Our personal experience investing with Prosper
Below is a screenshot of our Prosper summary page. It’s a little hard to read in this post so I’ll also point out some things for you.
We have been investing with Prosper for almost two years now. We started out with just a couple thousand dollars to “kick the tires” but as you can see we added more over time and have over $10,000 with them now.
Something I’m sure you all care about is the return we’re getting, so I’ll point out the annualized net returns – for our account specifically – has averaged 7.43%. Not too shabby!
Earlier I mentioned that the lenders can pick specific types of loans to invest in. You can see the mix that we decided on for our investment criteria. Currently we are holding loans with the following credit ratings: 43% AA, 30% A, 14% B, 8% C, 3% D, and 2% E. The higher the credit rating, the lower rate the people pay, so of course the worse the credit rating, the higher the rate. Those loans toward the lower end of the credit rating scale pay some really high interest rates. So why not just invest in the really high rate loans? Well, they also have pretty high default rates. There are usually good reasons that some people have poor credit ratings. But if we only invested in AA loans, our returns would be lower because of the great rates those borrowers have been approved for. In my testing it seems best to have a mix across the different ratings, but a higher concentration on the lower risk loans – like we do as shown above.
How many loans are we invested in right now? Hundreds – 19 of which are past due and in collections right now – which Prosper also handles automatically.
Notice the auto invest option there on our summary screen. You could just browse the hundreds of loans that are open, read the descriptions, and choose one at a time which to invest in, but that would be a huge hassle. The auto invest feature allows you to define certain criteria for the type of loans that you want to invest in and it will automatically make the $25 investments for you.
As people pay back the loans, your cash balance grows. Once your cash balance reaches $25 the auto invest feature kicks in and looks for a loan that matches your criteria. This makes it super-easy to stay invested all the time.
About that 7%+ return
Something to understand about the returns with peer-to-peer lending networks. Just like a bond investment, the portion of the money you get that is from interest payments (versus return of principle) is considered income and is taxed as such. When you invest in stocks you don’t pay taxes unless they provide dividends or when you sell the stock. This allows you to defer taxes until a much later time in the future – and pay a lower capital gains rate if you held the stock investment at least a year (as of 2016 rules).
Of course any loans that default will get written off and will help lower the reported taxable income, but still, there will be some income reported on your tax returns each year that you will need to include and pay taxes against. This isn’t a big deal – it’s all a part of income investing – but it is definitely something to just be aware of. The flip side is that you are paying taxes on the income each year, so if you withdraw your P2P funds in the future, you have already paid taxes on most of that and would only be liable for income since the last tax return.
Why not invest all your money here?
With 7.43% returns (as of this post’s date, over the past two years – of course subject to change both up or down), someone might think – hey, decent return, why not just put all your money here?
The main reason, for us at least, is that we are long-term investors and the tax deferral of a stock/fund investing account can wind up being a big deal over a twenty+ year investing period (*note on stocks below).
That said, this is yet another way to make sure your investing portfolio is diversified. It’s similar in function to holding bonds but with way better returns.
I feel very comfortable with a portion of our investment held at Prosper. Note that we have a rather large investment portfolio, so this is a very small percentage. If we had $50k I would not be putting $10k into this type of vehicle. I’d personally recommend just a couple percent of your total investments go into something like this.
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