I am of the mindset that is always looking for new and different ideas to make more money. I've spent so much money and time on books and reading, that I don't like to think about how much it's added up to! But hey…it's got it's perks, I learn from the experts and get to be ahead of the curve! That in turn has probably made me back all the money I've spent on books, and then some.
Why do I even bring that up? Because that's how I was introduced to peer to peer lending. In efforts of diversifying my investments, and seeking new and creative ways to put my money to work for me, I came across the idea of peer to peer lending.
In short, peer to peer lending allows me to play the bank, and lend my money out to lenders in need and in return I get to charge them an interest rate based on their financial situation. Why do you think banks are so wealthy? Because they get residual income and charge high prices for lending out their money.
What is peer to peer lending? And how do you invest money in online peer to peer lending sites? That will be the focus of this post. I'll explain to you how peer to peer lending works and how you too can take a piece of the potential 15%+ return on investment.
What is peer to peer lending and how does it work?
I'd be willing to bet that at some point in your life, whether it be in the past or present, you have acquired a loan of some sort from your local bank. That loan may have been for a car, for a home improvement, debt consolidation, school tuition, etc.
You went to the bank, asked for a loan, and they in return did a financial checkup on your financial profile and credit score, determined if you could qualify to pay back the loan, and ultimately determined an interest rate they would charge you should you be approved. That interest rate is simply the cost of borrowing money from the bank.
So you took out a $5,000 loan at a 6.99% interest rate for debt consolidation at which you agreed to pay back in 36 months time (3 years). Your loan payment comes to $154.36 each month. A small portion of every monthly payment goes towards paying down the principal loan balance, and the other portion goes to the interest rate charged for lending you $5,000. Lets do some basic math here:
- $154.36 x 36 monthly payments = $5,556.96
You borrowed $5,000 and paid back to the bank $5,556.96. The bank just made $555.96 off of you. That's why they have so much money.
But what if I told you that you could now play the bank's role in the lending process, and take a piece of that $555.96 return? What if the bank said we will contribute $4,500 of the loan and you contribute the other $500, and we will split the returns accordingly?
That is exactly what peer to peer lending is. Companies like Prosper and Lending Club bring together investors with money to invest, and borrowers needing loans. Investors can contribute as little as $25 to anyone loan requested, and each investor receives their proportion of the interest rate return. Make sense?
Things to keep in mind when investing in peer to peer lending
When deciding whether peer to peer lending is right for you or not, keep the following in mind:
Peer to peer lending Investment risk
First and foremost, keep in mind that there is always risk in investments. Just like a borrower may get in a financial bind and not be able to pay the bank back, so it can happen when investing in peer to peer lending.
Peer to peer lending companies like Prosper and Lending Club have put together underwriting criteria that allows them to check each and every individual loan application to determine whether they qualify to receive a loan or not. So it is important that when investing in loans like this, that you make sure your chosen company has a strong set of underwriting guidelines to make sure their borrowers are well qualified to pay you back.
A way to also avoid the risk of this happening is to invest in multiple loans. As mentioned earlier, you can invest with as little as $25 per loan, and in as many loans as you would like.
Loan terms – when you will receive your money back
Both Prosper & Lending Club have a few options for borrowers to repay their loan back, ranging anywhere from 12 months to 60 months. When choosing what loans to invest in, keep in mind that you will be tying your money up for the term of that loan.
Also keep in mind that by investing in multiple loans that over time this builds up a passive stream of income. How? By investing in multiple loans, you then create a stream of monthly payments being put back into your peer to peer lending cash account. You can use this as a form of income, or have it automatically reinvested back into more loans.
As this builds up over time, you could imagine having thousands or hundreds of thousands of dollars invested in these loans, that the payments each month could be enough to support some or all of your living expenses. This is true passive income…set it and forget it!
Different loan types and borrower financial strength
Taking into account what the loan will be used for can be a way of avoiding potential risks. It may be safer to invest in a loan that is being used to purchase a car, or renovate a home, than it would to invest in a loan that is being used to consolidate debt.
Each borrower will be given a financial rating to aid you in determining whether you want to invest in that loan or not. People with a weaker financial background (low income, bad credit, high debt) will offer a higher loan interest rate, and potentially higher returns. This also means it's a higher chance that they may miss a payment or have late payments as well.
Borrowers with stronger financial backgrounds (lots of income, little debt, great credit) will be safer to invest with and less likely that they will miss a payment. This also means that the interest rate for these loans will be lower, and thus a lower potential return for you as an investor.
How to get started investing in peer to peer lending
First off, you need to open an investment account with either Prosper of Lending Club. It's free to join. They will ask you for some personal information to open the account just as they would at a bank. Often times they require a first deposit to the account.
Once your account is open and funded, you can then begin to browse different types of loans and select which ones and how much money you would like to invest.
There are 2 major differences between Prosper and Lending Club to keep in mind. First, Lending Club requires a minimum account balance to be $1,000 before you are able to invest. Once you account has $1,000, you can then begin investing with as little as $25 each loan. This does not mean you need to have $1,000 invested, just deposited into the account you pull from when you decide to invest. Prosper on the other hand has no minimum balance requirements, and only requires that you invest at least $25 in each loan.
The average returns with each company is vastly different. With Prosper, returns have shown to be as high as 30% (obviously this is in riskier loans to get that high of a return) and anywhere below that. Personally, my portfolio is with Prosper, and I'm getting about 15% return as of this writing.
Lending Club has a much lower average return, somewhere between 7% – 12% based off of their website. This too of course for both Prosper and Lending Club can change over time as average loan returns are dependent on borrowers.
What does that tell you? It comes down to the simple “risk vs reward” principle. The higher the risk, the higher the potential reward. The lower the risk, the lower the potential reward. This means that based off of the estimated average returns, Prosper may have more options to invest in riskier loans, and Lending Club may be a bit more conservative.
Those are just a few things to consider when deciding where to start. Here I have written a full comparison between Prosper & Lending Club peer to peer lending platforms to aid you in determining which of the two is right for you to start your peer to peer investing portfolio. Check it out by following the link.
What pro's or con's have you seen or personally experienced with either Prosper or Lending Club? Post your comments and questions below!