Peer to peer lending isn’t a new idea. For most of history people were free to make loans to each other, and didn’t need the help of a bank to gain access to credit. Until the credit collapse in 2008, there wasn’t much of a demand for loans that didn’t originate at a bank.
There is no way to know for sure why peer to peer lending has taken off over the last decade. One of the biggest factors could be the record low interest rates that central banks have been using to prop up the global economy. The low interest rates that have supported the banking system may have serious consequences, which makes creating alternative systems even more important.
One way that banks make money is by lending money to retail customers at higher levels than it costs them. In an ultra-low interest rate world, banks were doing great on their lending activities, but their customers were in a bind.
Normal people don’t have access to money at the same rates banks do, which helped make peer to peer lending feasible for everyone involved. There are many peer to peer lending platforms out there, and they all specialize in different areas.
Peer to Peer Lending Cuts Banks Out
- 1 Peer to Peer Lending Cuts Banks Out
- 2 How Does Peer to Peer Lending Work?
- 3 For Lenders
- 4 For Borrowers
- 5 How to Prepare: Peer to Peer Lending
- 6 Top Peer to Peer Lending Platforms
- 7 Prosper
- 8 Prosper for Investors
- 9 How Prosper Works for Investors
- 10 How Prosper Works for Borrowers
- 11 Lending Club
- 12 Lending Club for Investors
- 13 Lending Club for Borrowers
- 14 PeerStreet
- 15 Fundrise
- 16 Funding Circle
- 17 Upstart
- 18 Peer to Peer Lending Makes Sense
Making a loan to your friend next door still isn’t easy to do legally. There are numerous laws that govern how money can be lent in developed economies, and banks like it that way.
Most banks make money by borrowing short term debt a low rates, then using that capital to originate long-term loans at much higher rates. The business model is very simple, especially when short term rates are extremely low, while longer term interest rates are hundreds of basis points higher.
Peer to peer lending is designed for accredited investors who have a higher-than-average income. This requirement is in place because the regulators think that peer to peer lending carries substantial risk to the lender, and isn’t right for regular people.
Another reason why banks and regulators may not like to see peer to peer lending grow is because it could have a material impact on one of the most profitable areas in banking. It is very easy to make money by originating loans that don’t cost much, then charging a much higher rate of interest.
How Does Peer to Peer Lending Work?
At its most basic level, peer to peer lending is extremely simple. An authorized investor chooses to lend a borrower money, which is then paid back with interest. In practice, peer to peer lending is a little bit more complex.
The draw for lenders on for-profit peer to peer lending sites is the above-market rate of return. At the moment most bank deposits won’t yield much, and the risk/reward balance on high-yield bonds has been out of whack for years.
Investors who want a return are forced into choosing to buy stocks at record high prices, or some form of debt which may or may not be a good investment at this time. Peer to peer lending is a very different arrangement.
Lenders on peer to peer lending sites connect directly with borrowers to make a loan. When a bank is cut out of the lending equation both sides get a better deal. For a lender, this means getting most of the interest a borrower pays for the loan, if they don’t repay it early.
Of course, making loans is a risky business. Peer to peer lending sites recommend that lenders spread out their investments, so that a few defaults don’t wipe out all the investment capital. This is more or less the same strategy that high-yield bond investors use, but on a much smaller scale.
Despite the fact that credit costs are at all time lows, the interest rate that many retail borrowers have access to is still relatively high. Additionally, banks love to build fees into their loan agreements.
Banks actually make a ton of money from designing hard to understand terms and conditions, which can end up costing borrowers more money than they expected. Peer to peer lending platforms generally cut borrowers a better deal on a loan than a bank would, and they mostly use simple terms.
Another big plus to using peer to peer lending sites is that they almost universally don’t charge borrowers anything if they pay off the loan early. If you pay off your loan before the term is over, you will actually be getting a substantial discount on the loan, as you save a lot in interest payments.
On the downside, peer to peer lending platforms may not be in the same position to make a deal on a package of debt as a full service bank would.
If you have decent credit, and an existing relationship with a major bank, the bank may be willing to bundle all your debt together and refinance what you owe at lower rates. Additionally, the amounts of debt that peer to peer lending platforms generally offer are lower than major banks, who can make just about any kind of loan they want.
How to Prepare: Peer to Peer Lending
Like anything in the world of finance, it is a good idea to start with your goal in mind.
If you are looking for a loan on a peer to peer platform, you will need to know if that platform supports the kind of lending you want. As a borrower, you will need to provide extensive information before you receive any money. Your credit score will also determine what kind of interest rate you receive, just like at any other lender.
For lenders on peer to peer lending platforms, the situation is a little different. There is a lot of strategy that goes into making loans. Any of the peer to peer lending platforms on this list will advise you to spread your investment money out over a number of borrowers, to minimize default risk.
In addition to diversification across a number of borrowers in the same risk category, it may also be a good idea to diversify into different categories of default risk. The more likely a borrower is to default, the higher the rate of interest they have to pay. By adding some high-yield obligations to your lending portfolio, the overall rate of return may shoot up.
Top Peer to Peer Lending Platforms
If you can obtain a loan from a bank or credit union, there is a good chance you could save a little bit of money by borrowing from one of the peer to peer lending platforms below. In addition to potential cost savings, peer to peer borrowing means that another person will get the interest payments, not a massive bank.
Prosper was the first peer to peer lending platform available to US investors when it opened up its digital doors back in 2006. Many investors stayed away from the platform due to early setbacks, partly due to risk control measures at the firm, and also the the general investment climate of the time.
As the peer to peer lending space has grown, Prosper has done a lot to improve its business model. Now, Prosper has higher standards for its borrowers, and produces consistent returns for investors who choose to use the platform.
Read: Our Review of Prosper
Prosper for Investors
Prosper underwent a big change in how they appraise risk in 2009. Today, investors at prosper are getting similar returns to any of the other major peer to peer lending platforms. Signing up to Prosper is a straightforward process, as long as you meet its criteria.
If you aren’t an accredited investor, you don’t have to worry. Prosper only requires that you invest $25 USD. While it is probably a very good idea to invest more, so you can diversify, Prosper is accessible to just about any investor.
Prosper also allows you to roll over your 401(k) savings accounts, or just open a brokerage account that is taxed normally. Although Prosper is totally legal in the USA, there are a number of states that don’t allow residents to participate in peer to peer lending platforms.
At the time of writing, residents of Alaska, California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Louisiana, Maine, Michigan, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New York, Oregon, Rhode Island, South Carolina, South Dakota, Utah, Virginia, Washington, Wisconsin, Wyoming, the District of Columbia can use Prosper to invest their money.
How Prosper Works for Investors
Once you have opened an account and funded it, all you have to do is decide which ‘notes’ you will invest in. The minimum amount that a note can represent is $25 USD, but unlike other platforms, Prosper allows notes to grow in any dollar increment.
Clearly, the more notes you buy, the greater your diversification will be. Prosper allows you to dig into the borrower’s application, and read about why they want to borrow money. The platform recommends that you invest at least $2500 USD, and spread it across 100 borrowers.
Loans on Prosper aren’t insured, so if your notes default, you will lose the investment. Most investors report that they are able to make around 5% per year on the platform, though taking higher risks may boost that amount if you have good luck.
The loans are rated from AA to HR (High Risk), and the annual rate of return for each risk category is clearly displayed (based on actual returns).
How Prosper Works for Borrowers
Applying for a loan with Prosper is a lot like applying for a loan at a bank, or any other lending institution. You will be asked a lot of personal information, as well as permission to have your credit score. You must have a credit score of at least 640 to qualify as a borrower on Prosper, and the amount of money you receive will be up to the lenders on the platform.
Borrowers on Prosper Have to Disclose:
- Reason for Borrowing– Lenders want to know why you need the money, and what you plan to use it for.
- Employment Situation– You will have to disclose what you do for a living, and if you are self-employed.
- Term of Loan– You can borrow for a few months, or years. Some investors prefer to finance certain time periods, but there are other factors that are probably more important.
- Income– While you can leave your income unspecified, the likelihood of attracting investors is much lower.
- Prosper Rating– Based on the information you supply, Prosper will assign you a rating from its proprietary system. The better the rating, the lower your rate, and the more likely you are to attract capital.
- Inquires– The number of times your credit history has been pulled in the last 6 months will appear to potential investors. Lower is better!
- Credit History– Like any loan granting platform, Prosper will display your credit history to potential lenders. The longer your credit history, the better.
- Public Records– If you have defaulted on a debt, or gone bankrupt, it will be a matter of public record. Clearly, any public records are bad.
- Debt to Income Ratio– Any debts you have will be used to calculate your debt to income ratio. Some lenders care about it, others don’t.
- Previous Prosper Loans– If you have used Prosper before, potential lenders can see how you performed. A clean record will help you attract more loans!
If and when you are given money by lenders on the platform, you will have to repay the money via the terms of the contract. Any money you are given will be wired to your bank account, and you can pay your loan via AutoPay, or check.
Lending Club was another innovator in the peer to peer lending space. Unlike Prosper, Lending Club has always helped create good returns for its investors and has developed great risk analytics. Lending Club is a good place to look if you are a lender. It is also worthwhile if you want to borrow money and have a good credit history.
The borrowers at lending Lending Club tend to have good credit histories, and an average income of above $70,000 USD. The rate of return at Lending Club is more or less on-par with other peer to peer lending platforms, like Prosper.
One of the best uses for a platform like Lending Club is debt consolidation. After the financial crisis in 2008 hit, credit card interest rates shot up. Higher interest rates for the same amount of debt mean less money in your pocket every month, which is why using a peer to peer loan could make sense for people with thousands of dollars in high-interest debt.
Lending Club for Investors
Lending for a profit is pretty easy on Lending Club’s peer to peer lending platform, if you are eligible to use it.
Unlike Prosper, you will need to have an annual income of over $70,000, or total assets of $250,000 USD or more. These requirements are in place to keep smaller retail investors safe, and they also allow Lending Club to operate more US states than Prosper.
At the time of writing, residents of Alaska, New Mexico, North Carolina, Ohio and Pennsylvania aren’t able to use Lending Club due to state laws. Other than that, anyone in the USA can use the platform!
The account minimum at Lending Club is $1,000USD for regular accounts, and $5,000 for IRA accounts. Lending Club offers a range of IRA account options, and will help you rollover your existing retirement account if you want to use its platform to save for your future.
Lending Club has the same note size as Prosper, and you can invest your money in $25 USD increments across a range of risk categories. The company uses a ranking system from A1 (least risky), to E1 (most risky), and will report any defaults to US credit agencies.
If you have a lot of money to invest with Lending Club, it offers an automated system to invest along parameters you establish. This kind of system does have some drawbacks, as you will not be able to make sure that every note you buy will be reviewed personally. There is also a secondary market where you can sell the notes you buy, though there is no guarantee of a buyer for the notes (there is no market maker or liquidity provider in the secondary market).
Lending Club for Borrowers
Lending Club has no problem attracting investors because it has some of the best risk control measures in the peer to peer lending industry. In addition to all the information that Prosper requites from borrowers (see above), you have to have a FICO score of over 660 to use Lending Club.
According to the company, Lending Club refuses 2/3 of the people that apply to the platform. Interest rates range from under 6.5% for borrowers with the best credit history, to over 30% for borrowers that are at the lower end of its acceptable limits.
Borrowers at Lending Club can borrow as little as $1,000 USD, up to $40,000 USD. All loans are fixed-rate, and range from three to five years in duration. All loans are unsecured (like a credit card), and can be taken out for small businesses, refinancing autos and also to cover medical bills.
PeerStreet is a similar idea to Proper or Lending Club, but it is focused on specialty real estate loans. The debts that PeerStreet helps originate aren’t a Real Estate Investment Trust (REIT), and they are collateralized by the properties that investors lend against.
The minimum account size at PeerStreet is $1,000 USD and the accounts are FDIC insured (against custodian insolvency, not borrower bankruptcy). Otherwise the PeerStreet is similar to any other peer to peer lending platform, and gives lenders a way to access loans that typically yield between 6%-12% annually that are backed-up by real estate.
Fundrise is another real estate focused peer to peer lending platform. It is basically a REIT that allows investors to put their money to work in income producing real estate investments. Like PeerStreet, investor’s money is backed up by the real estate that the REIT invests in, which is an added level of security.
The company posts its annual returns on its website, and in 2016 Fundrise returned more than 8% to its investors. There are a lot of REITs out there, so it might be a good idea to compare Fundrise to other options in the marketplace. One big advantage that Fundrise has is the low minimum investment of $1,000 USD, which makes it very accessible to smaller investors.
Funding Circle makes loans to small businesses, which is a sector that tends to be underserved by the existing banking establishment. Small business can access loans from $25,000 USD to $400,000 USD on the platform, and all loans are fixed-rate. So far, the platform has lent more than $2 billion USD, and offers rates that start at less than 6% per year.
Upstart is a relative newcomer to the peer to peer lending market. It looks for ‘future prime’ borrowers who are likely to want a good credit record. The average Upstart borrower has an income of over $100,000 USD, and a FICO score of 691. The platform could be worth a look if you are younger, and want to start building a solid borrowing history.
Peer to Peer Lending Makes Sense
In the wake of 2008, people began to realize that banks aren’t the benevolent institutions that many thought they were. Even though interest rates have been slammed to the floor for a decade, the interest rates that consumers have to pay seem to be static (or rising).
Peer to peer lending offers both borrowers and lenders a way to escape from the banking system, and make loans directly to other people. Removing banks from the credit creation business helps both parties, and lets investors make a return on their hard earned cash.
The peer to peer lending space is still getting started. It looks like it could keep growing, and make life easier and more profitable for everyone involved!