The peer to peer lending industry has continued to grow as more borrowers seek alternative sources of capital. A recent research predicted that the industry will have a compounded annual growth rate (CAGR) of more than 50% through 2022. This growth is driven by the individual and corporate borrowers who are in a constant need for money and investors who are hungry for yields. This article will explain what peer to peer credit is, how to use it, and the precautions to have in mind while looking at Peer to Peer Lending as an Investment.
What is Peer to Peer Credit?
The peer to peer credit has been around for decades. This is because people have been borrowing money from one another for that long. In recent years, the industry has scaled because of technological advancements like machine learning and artificial intelligence. This resulted in large platforms for peer to peer lending and crowdfunding loans.
With these platforms a borrower who needs money can go to the platform and borrow while an investor who needs money to grow can lend the person. In essence, this is a similar way to which banks traditionally managed their loans. They would the customers deposits, lend them to customers, and pocket the difference (though banks these days have the advantage they can just borrow money from the central banks as well).
In the United States, the industry has been helped by a number of companies. The largest peer to peer lending platform in the country in 2019 is LendingClub, which has a market value of more than $1.5 billion. Lending Club is followed by companies like Prosper, Upstart, and FundingCircle among others. For a comparison, check out our information on the best peer to peer lending platforms for investors.
In October 2020, Lending Club ceased all new loan accounts as it is transitioning into an online bank, LendingClub Bank, after the acquisition of Radius Bank. As of December 31, 2020, Lending Club no longer operates as a peer-to-peer lender.
How Peer to Peer Credit Works
While there are many companies in the industry, they all work in a similar way. They provide a platform for both borrowers and lenders, and risk assessment tools for the investors.
In this platform, a lender can deposit their funds and view all the people who are in need of the funds. These borrowers are classified in line with their FICO scores and other credit rating metrics. Then, a lender selects the people they want to lend to. After investing, the lender will receive the interest and repayments in their accounts.
Alternatively, lenders can also let the algorithms decide on the best people to lend money to. This type of algoritmic lending makes investing in peer to peer loans a very easy and automised endeavour. Especially platforms such as Bondora Go & Growth make investing super easy.
Why Invest in Peer to Peer Credit?
With so many areas to invest in the US like stocks and real estate, the question many people have is why they should invest in the peer to peer industry. Here is a summary of those reasons:
- Investing in peer to peer credits is a good way to diversify your returns.
- It is also a good way to make passive income because after lending, you will just receive the interest.
- You may get higher returns. Most of the platforms promise higher returns than the US treasuries.
- Peer to peer lending platforms offer a number of ways to diversify the credit.
- The platforms are easily accessible to get started with investing.
- You will have the ability to invest in high-yield credit like banks do.
- There are only small fees.
Risks for Peer to Peer Lending
Like in all investments, peer to peer lending comes with its own risks. These risks are classified into four: market risks, platform risks, performance risks, and liquidity risks.
Market Risks in P2P Lending
The market risk relates to the macro-performance of the economy. In case of a large economic downturn, there are chances that many borrowers will not be able to pay back their funds. When this happens, you risk losing your entire investment. In addition, if interest rates rise to pre-financial crisis levels, it would be unwise to be invested in these platforms because you will generate lower returns.
Platform Risks in P2P Lending
Most of the companies operating in this sector are relatively new and most of them make losses. For example, in 2018, LendingClub made losses of more than $128 million. Therefore, there is a big risk investing using a loss-making platform as an investment vehicle. In addition, since these companies are mostly online, you are exposed to cybercrime.
Liquidity Risks in P2P Lending
After funding a customer, it is very difficult to get the funds back before the loan matures. This presents you with the challenge of lacking funds when you need them the most. For example, if you have invested in stocks, you can easily sell the stock when need be.
Performance Risks in P2P Lending
The P2P platforms like FundingCircle have put in place measures to ensure that the lenders pay back the funds. For example, they scan their social media platforms and their FICO credit scores. However, this does not provide enough cover for them, which means that customers can default. If they do, you will lose the money because the loans are non-collateralized.