Peer-to-Peer lending, also abbreviated as P2P lending, is a form of debt financing that provides the means for individuals to borrow and lend money from each other through an online platform. This means that P2P lending allows people to borrow money without the use of traditional banking services.
P2P lending can be categorized as a form of alternative finance service.
How does P2P lending work?
When wanting to know how P2P lending works, it’s a good idea to think about how the traditional debt market works. Here the banks typically lend out money to people and expect to get interest payments in return. This way, the bank earns money for its owners, and to pays its employees.
Peer-to-Peer lending essentially cuts out the middleman or in this case the banker. This can make P2P lending a great product for both the borrower and the lender, as it can be cheaper for the borrower while giving better a return for lenders. Of course, the investors take the place of the bank, which leaves an important thing out of the equation: The credit rating.
The credit rating of P2P loans is instead of being performed by the banks, often performed by the platform, where the loans are listed. This is often done for a fee but is still a more cost-efficient way of performing credit ratings, which leaves out profit for the investors.
Much like crowdfunding
Also known as crowdlending, P2P lending actually also works a bit like crowdfunding. You probably know by now, that crowdfunding is a way to raise money for a project. Here you will often get a product in return for helping fund a given project. With crowdfunding, a project is funded by 100s, 1,000s, 10,000s, or even 100,000s of people. The same goes for P2P loans. But instead of getting a product, the funders of a P2P loan will receive interest on their money. And instead of being funders, people who fund a P2P loan is fact investors.
In its most direct form, a P2P loan is listed on a platform. Here investors can pool a bit of money into the listed loan. Oftentimes people invest in 100s, if not 10,000s of different loans with a small amount of money like $5-10 in each loan. In that way, they eliminate much of the risk of a single loan while enjoying the benefits of the return.
Is Peer-to-Peer lending safe?
You might question whether is safe to invest your hard-earned money into Peer-to-Peer lending.
The short answer to the question is: It depends.
Like with any other investment, P2P investing also come with a set of risks. A general rule of thumb is that risk follows reward. In investing, this means that the more reward you seek, the more risk you will have to take. This means that P2P lending is just as safe as you make it be. Investing in only loans with a +20% annual return might prove to be a bad idea down the road.
In the following, you will learn more about how to invest in Peer-to-Peer lending without running too high of a risk.
How to invest in Peer-to-Peer lending?
If you want to invest in P2P lending, it’s important to take a few precautions. If you don’t do that, you can end up losing a lot of money. Luckily, the precautions you need to take aren’t really that difficult and borders common sense. Let’s take a look at the steps you need to take:
1. Choose the best P2P platform for your goals
The first step you have to take is choosing the best P2P lending website for you and your investment goals. Here you can use our site to compare P2P lending platforms. The platforms featured on our page have been through our due diligence process before being listed. This means that we have left out a lot of platforms which does not live up to our standards. However, it is not all platforms we have reviewed. This means that you can also find good platforms that are not listed on our site. We just aim to provide a good starting point for beginners.
If you are looking for a beginner-friendly P2P platform, you might want to check out our Mintos review. This is one of the most popular platforms among new P2P investors.
2. Invest small in each loan
One of the most important things to remember is that a borrower can always default on their loans. It can happen for many reasons, but let’s say that you invested in 1,000 different loans. Here it would be quite surprising if not one of the borrowers defaulted on their loan.
Let’s say you only invested in one loan and the borrower defaulted. You want to avoid that situation no matter what. Therefore, it’s a good idea to invest maybe $10 in each loan, until you have a substantial amount of loans in your portfolio. Hereafter, you can slowly raise the maximum amount invested per loan. But remember that it’s always a good idea to keep the amount low.
Even though some P2P marketplaces offer a buyback guarantee, it is still a good idea to only invest a small amount in each loan.
3. Use multiple P2P lending platforms
Lastly, it can be an excellent idea to use more than one P2P lending platform. This is due to the fact that the P2P lending marketplaces often carry a bit of risk themselves.
Imagine a worst-case scenario where a platform went bust, and the loan contracts weren’t made properly. If you then invested an equal amount of money split between 4 platforms, your loss would be around 25% of your portfolio. If you had only invested through one platform, and it was the one that went bust, you could potentially end up with a 100% loss.
It might not be likely, but it’s always a good idea to consider worst-case scenarios when investing.