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Is Peer To Peer Lending A Good Investment?

7-minute readSeptember 21, 2020

Over the past several years, peer-to-peer lending, also known as p2p lending, has become a popular way for borrowers to access cash without going through traditional lenders. Often times you can find some very low interest rates as long as you have a good credit score. But what people love to most is how easy the application can be compared to the traditional bank.

Let’s dig into peer-to-peer lending a little more and see if it might be a good option for you.

What Is Peer-To-Peer Lending?

Peer-to-peer lending is a way for someone to borrow money online from another person. There are a handful of well-known platforms, such as LendingClub and Prosper, that facilitate the transactions between the borrower and the individual lending the money.

Because the peer-to-peer lending process eliminates the middleman – in this case the bank – it can be a win-win for both parties involved. The borrower is going to have the opportunity to borrow money at a lower rate, plus the person investing the funds is going to still earn a nice return on their investment.

As an example, you might be able to go into your local bank and take out a loan with an interest rate of 15%. Or you can get a p2p loan with an interest rate of 10% where the investor receives an 8% return. You’ve saved 5% on the cost to borrow money plus the investor has earned a nice return on their investment.

How Peer-To-Peer Lending Works

The basics of how peer-to peer lending works is pretty straightforward. Once you’ve chosen a platform you want to use, you’d need to fill out an application. After you’ve made it through the application process, the peer-to-peer platform will perform a credit check. To do this, they’ll do a hard pull on your credit report.

Next, you’re going to see the interest rate you’re eligible to receive. If you approve of this rate, you can then move onto the funding stage. This is where investors will look at your request and decide if they’d like to lend you the funds or not. Once an investor has taken on your loan, the funds will be transferred into your bank account. Depending on the p2p loan platform, this can take a couple of days or a couple of weeks.

Once your loan has been funded, you’ll start making monthly installment payments to pay back the loan. If your loan has multiple lenders, your payment will be split up proportionately among all of them.

Common Types Of P2P Loans

You can choose to take out a p2p loan for a number of different reasons. Maybe you have high-interest credit card debt that you’d like to pay off quicker. Maybe you’re looking to make some improvements to your home and need some additional funds. Let’s take a look at a few of the common types of p2p loans.

Personal Loans

One of the most common types of peer-to-peer loans is a personal loan. The funds can be used for a long list of reasons. Maybe you’re planning to get married and need some extra cash to pay for the wedding. Or you could have credit card debt that has a high interest rate.

You might be wondering what the difference is between a traditional personal loan and a peer-to-peer loan. The answer is the source of the funding. Personal loans typically are funded by banks and other types of lending institutions. Peer-to-peer loans are funded by individual investors.

Business Loans

Are you starting a business? There’s a good chance you might need extra cash to get on your feet. Maybe you need to purchase equipment or product. If so, using a peer-to-peer loan can give you the cash you need to get your business up and running.

Student Loans

If you’re one of the millions of Americans who have student loan debt, you might be looking for a way to lower your monthly payments. One option that most people don’t even think of is a peer to peer loan. Some student loans could have a variable interest rate. During a volatile time for interest rates, your payments could fluctuate pretty frequently. When you refinance with a peer to peer lender, you can lock yourself into a fixed rate so your payment amount will stay constant each month.

Big Names In Peer-To-Peer Lending

If you’re considering a peer-to-peer loan, it’s important to shop around like you would for anything else. Different platforms might offer different interest rates, which can have a big impact on your borrowing costs. Here are three of the most popular peer-to-peer platforms.

LendingClub

LendingClub is the largest and most well-known peer-to-peer lender. You can borrow up to $40,000 when taking out a personal loan, but that number can go up to $300,000 when applying for a business loan. Rates start at 6.95% for borrowers with the best credit.

Prosper

In 2005, Prosper became the very first peer-to-peer lender. One of the nicest things about Prosper is that you’re able to see what your interest rate would be without having a hard credit check impact your credit score. You can choose from either a 3- or 5-year loan term with a fixed interest rate.

Upstart

Upstart looks at more than just a borrower’s credit score when reviewing their application. They also consider your educational background, your field of study and your job history. You can borrow up to $50,000 with interest rates as low as 6.53%. Take out a loan for either 3 or 5 years and rest easy knowing that if you want to pay off the loan early without penalty, you can.

Qualifying Factors Considered by P2P Lenders

Applying for a peer-to-peer loan through one of the major platforms can be a pretty simple process. Here are a few of the main things each will consider when determining if they’re going to lend to you and what the terms will be.

Credit

No matter if you’re applying for a peer-to-peer loan or a mortgage, your credit score is going to be one of the most important factors the lender will consider. Your credit score can be a direct representation of the type of borrower you might be. If you have a credit score on the lower end, you might seem like a higher-risk borrower. Higher risk doesn’t always mean you won’t be approved, but it almost always means your loan will come with a higher interest rate.

Most peer-to-peer lenders have minimum requirements when it comes to lending. For example, LendingClub requires at least a 600 credit score while Upstart is a little lower at 580.

DTI Ratio

Another qualifying factor for peer-to-peer lenders is your debt-to-income (DTI) ratio. This number will look at the total amount you owe every month and compare it to your total income. If you’re unsure what your DTI ratio is, you can figure it out pretty quickly on your own. Add up everything you owe each month. This includes things like rent/mortgage, student loan payments, car loans, minimum credit card payments, etc. Once you have a total debt payment, divide that number by your monthly income. An excellent DTI ratio would be anything under 20%.

Purpose Of The Loan

Finally, the reason for the loan is going to be a qualifying factor as well. Most lenders want to see that you’re going to use the money for the right purpose. This could include things like paying off credit card debt faster, making improvements to your home, lowering the interest rate on your student loans.

Pros And Cons Of Borrowing From P2P Lenders

If you’re looking for a way to borrow money without actually going through a traditional bank, peer-to-peer lenders are a great option. They have some pretty strong advantages, but there also some downsides you should consider.

Pros

Lower rates: Depending on your credit score, peer-to-peer loans are often times going to provide you with lower rates. This is because banks and credit unions have so many overhead costs to run their business that they need to pass the costs along to their customers.

Perfect credit history isn’t required: Credit scores definitely matter in the lending process, but peer-to-peer lenders aren’t looking for perfect borrowers. Even if you have some small missteps in your credit history, you can still be approved for a loan.

Easy Process: The process of getting a loan through a peer-to-peer lender is virtually painless. This is a major difference from traditional lending where you might need to wait weeks after the application process for your loan to actually be approved and paid out. With peer-to-peer lending, you can have a decision and funds within just a few days.

Cons

High interest rates are possible: If you have less-than-stellar credit, your loan could cost you more money in the long term. With most peer-to-peer lenders, lower credit scores mean higher interest rates, sometimes as high as 35% or more.

Missed payments can affect your credit: Missed payments on peer-to-peer loans will hurt your credit the same way as any other form of debt.

Investing In Peer-To-Peer Lending

Some people use peer-to-peer loans as an alternative way to borrow money. Others use them as a way to diversify their investment portfolio. There is a lot of opportunity to earn high returns from peer-to-peer loans, but it can come with risk. If you choose to invest in a borrower who has a lower credit score or other high-risk characteristics, the return is going to be much greater than someone with excellent credit. However, the risk of defaulting on the loan is going to be higher. Like any other investment, it’s important to invest according to your own risk tolerance.

Is Peer-To-Peer Lending Worth It?

Peer-to-peer lending can be great for both borrowers and investors alike. Because they cut out the bank, acting as the middleman, the borrowing costs are going to be less and the potential investment returns are going to be higher. However, before you think about peer-to-peer lending, it’s important to do your research to make sure it’s the best fit for you.

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