If you’ve ever looked into getting a personal loan, you most likely heard the term “peer-to-peer lending.”
You imagine your best friend loaning you $50. That must be what peer-to-peer lending means … right?
Peer-to-peer lending (also known as P2P lending) is handled by companies like Lending Club and Prosper. These groups connect consumers (who need an unsecured loan) with investors who have the money available to lend.
When we say “investors,” we’re not talking about bankers on Wall Street. We’re referring to your next-door neighbor Joe, who has an extra $5,000 after getting his holiday bonus and wants to invest in something other than the stock market.
It’s essentially a way for regular, everyday people to borrow money from regular everyday people.
How P2P Lending Works
Because the entire process is online, peer-to-peer lending companies essentially run credit marketplaces which operate with lower costs than traditional banks or credit companies. This means they are able to offer lower interest rates to borrowers and better returns for investors.
“Borrowers who used a personal loan via Lending Club to consolidate debt or pay off high-interest credit cards report in a survey that the interest rate on their loan was an average of 33% lower than they were paying on their outstanding debt or credit cards,” according to Lending Club’s website.
Since there are no banks or credit lenders involved, borrowers are able to qualify for loans with much lower interest rates than they could otherwise. P2P lending attracts investors since their money grows much more quickly through P2P lending than it would through more traditional investment accounts.
How to Qualify for a P2P Loan
If you’re interested in consolidating your debt through a P2P loan, you’ll need to take a few steps:
Live in the right state
Not all states allow P2P lending practices. As of the end of 2015, 48 states allow its residents to borrow money from Lending Club (every state except Iowa and Idaho), while 47 states allow residents to borrow money through Prosper (every state except Iowa, Maine and North Dakota).
Submit an application
Once you submit an application, the lending company will determine if you qualify for a loan by assessing your credit score and borrowing history. Qualified applicants can start receiving loan offers from $1,000-$35,000 in just minutes.
Have a good credit score
Most P2P lending companies require you to have a credit score of at least 640 to qualify for a loan. Your credit score will determine your “loan grade,” which determines your interest rate.
The loan grade you’re assigned acts as a signal to investors, telling them how much risk they’re assuming by giving you a loan. A loan grade of A1, for example, has the lowest risks and the best interest rates, whereas a G5 loan means you have a lower credit score and bring more risk to the table.
Interest rates range between 6.16% and 35.89% for Lending Club and 5.99% to 36.00% for Prosper.
How to Become a P2P Investor
If you want to become a P2P investor, you have to prove you have the money available to back up your loans. A net worth of $250,000 or more, or a gross annual income of at least $70,000, is required. Investors usually pay 1% of their investment earnings to the P2P lending company.
You also need to live in a state that allows its residents to be P2P investors. As of now, 36 states let residents invest through Lending Club, while 32 states allow residents to invest through Prosper.
P2P Investing With Student Loan Debt
Could you use P2P lending to become an investor – even while you still carry student loans?
Yes, you can. However, “can you?” is a different question than “should you?” Let’s explore the arguments for both.
Let’s assume you hold student loans with a 5% interest rate. You invest money through a P2P website and (hypothetically) earn returns of 9%. (This is purely for illustration purposes and does not make any claims of actual returns.)
You could, in theory, pocket the 4% “spread” and use these gains to repay your existing debts.
However, as with all investing options, becoming a P2P lender does come with certain risks. Here are several risks you should consider:
1. Borrower default
Peer to peer loans are unsecured loans, which means the lender has no recourse if the borrower stops making payments. Without collateral — such as a car or a home — backing up the loan, there isn’t much you can do if your borrower defaults besides report their default to the credit bureau once their payments are 150 days past due.
If your loan ends up being “charged off,” it means the lending company will deduct the remaining principal from your balance, and you will have to take that loss.
Unfortunately, as an investor, you will most likely experience default at some point during your time in money lending.
2. Bankruptcy of the lending company
As an investor, you would be putting your faith in the P2P lending company, namely Lending Club or Prosper. What would happen if the company were to go bankrupt? Would you be able to retrieve your initial contribution?
It’s unlikely that either company will go belly-up anytime soon, but it’s worth considering.
3. Changes to P2P through government regulation
In December 2015, Chinese regulators released a draft of new rules for Chinese P2P lending platforms. While the U.S. hasn’t made any concrete regulatory changes as of yet, we may see more government interest in P2P lending practices.
Right now, the SEC manages the peer lending industry, much like it manages stock brokers and lending banks (which follow very different rules). If the government were to take a sudden interest in making sweeping changes and regulations, your investments could be affected in ways that are hard to predict.
Should the risks stop you from investing in P2P lending? That’s your own judgment call. All investments carry an inherent level of risk, and P2P lending can potentially be a great way to diversify your investments.
And if you’re a borrower? Getting a loan through Lending Club or Prosper could be the solution you need for securing a loan. P2P loans offer much lower interest rates on personal loans than banks and credit companies, meaning they could help save you a lot of money in the long run.
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