According to a recent report from Allied Market Research, the global peer-to-peer (P2P) lending market in 2019 was valued at $67.9 billion—a hugely impressive figure for an industry that’s only about 15 years old. Given this phenomenal pace of growth, it’s hardly surprising that P2P lending has become a popular passive income stream among investors looking for higher potential rewards than those offered by more conventional forms of investing. If you’re curious about whether P2P lending is the right passive income choice for you, read on for a closer look at what this innovative industry is all about.
What is P2P lending?
As the name implies, peer-to-peer lending is an alternative financing system that directly connects individual borrowers with individual lenders. Until recently, if you wanted to borrow money to buy a car or pay for college, your only option was to obtain a loan from a bank.
P2P lending, however, cuts out the “middleman” role traditionally occupied by financial institutions. Instead, the system uses online platforms to match borrowers looking for a loan with lenders looking to invest their money, in much the same way a platform like eBay removes the intermediary (a retail store) between buyers and sellers. The idea behind P2P lending is that with no middleman, costs are greatly reduced, allowing lenders to reap greater returns and borrowers to enjoy lower interest rates.
How does P2P lending work?
To get started with P2P lending, the first step is to sign up with a P2P website or online platform. You’ll open an account with your platform of choice and deposit whatever sum of money you’re planning to invest—this is the amount you’ll be able to disburse in loans to the P2P borrowers on the site. You’ll also need to decide what interest rate you’d like to receive and for how long you want to loan your money. Typically, most P2P loans are between $2,000 and $35,000 and run between three and five years.
The P2P platform will then match you with potential borrowers using sophisticated algorithms that take various factors, such as the borrowers’ credit risk, into account. You can then bid on the opportunity to finance individual loans, or you can choose to have the P2P company distribute your funds among multiple borrowers. Note that at no time do borrowers and lenders ever learn each other’s identity. Privacy is an essential element of P2P lending and anonymity is strictly maintained.
What are some examples of P2P lending platforms?
Currently, there are dozens of P2P lending sites in operation in the US market, and each one is a little different (some platforms specialize in particular types of borrowers, for example, or particular types of loans). Examples of P2P platforms include:
Prosper—Prosper’s claim to fame is its status as the original P2P lending site. Founded in 2005, Prosper and has funded loans worth more than $17 billion to over 1 million people.
Lending Club—Another early P2P lending site, Lending Club was founded in 2007 and has since grown into the Internet’s largest P2P lending platform. Most of the lending transactions facilitated by Lending Club are personal loans of up to $35,000.
SoFi—Short for Social Finance, SoFi specializes in student loan refinancing, an area that has not been adequately served by the traditional banking industry before now. According to SoFi’s claims, members who refinance their student loans on the site can save an average of $14,000.
What are the pros and cons of P2P lending?
Like any other form of investing, P2P lending has its pros and cons, and it’s important to carefully consider these before deciding to become a P2P lender.
Pros—For individual investors, the biggest benefit of P2P lending is that it can bring significantly higher returns. For example, by investing in a P2P platform, it’s possible to get returns of up to 10 percent per year depending on your portfolio of loans; if you invest in a 10-year US Treasury note, on the other hand, you’ll get just 1.82 percent per year. Other pros of investing in P2P lending, as reported by other lenders, include a strong sense of community among lenders and a charitable aspect to the lending (i.e., you can make sure your money is going to someone who really needs it).
Cons—Higher rewards usually go hand in hand with higher risk, so it’s not surprising that an increased element of risk is the major downside of P2P lending. With few exceptions, funds are not insured, so you could face exposure if a borrower defaults on their loan. Also, you can’t always withdraw money early from P2P loans (or you may face high fees for doing so). Finally, there is always the possibility that the P2P site itself may go out of business. In 2019 the British P2P company Lendy collapsed, leaving roughly 9,000 P2P investors out of pocket for nearly $199.5 million in loans.