Bill Gates once said, “Banking is essential, banks are not.” Peer-to-peer (P2P) loan companies have been trying to prove him right by cutting brick-and-mortar banks out of the lending process, passing savings to lenders and profits to investors.
For investors earning next to nothing in savings accounts, P2P loans can be an attractive alternative. In the past five years, average returns on Lending Club and Prosper—two of the largest and most popular P2P companies—ranged from 5% to 9%. In an environment where a 1% interest rate is considered good, returns like this are stellar. Let’s look at the current landscape of P2P loan investing to see if it is right for you.
What is P2P Lending?
Peer-to-peer loans are simply loans made over the internet from one “peer” to another.
In the old days, someone seeking a loan would go to a bank, ask for a loan, and be given the money from someone else’s savings account. The borrower would pay interest to the bank, and the bank would pay interest to the saver. The difference between the rate the borrower paid the bank and the rate the bank paid the saver was the bank’s profit.
P2P lending cuts the bank out, allowing people whose money might otherwise be parked in low-yielding savings accounts to lend money to borrowers, thus making money like banks do. While P2P marketplaces are still middlemen, they operate a much lower cost structure than brick-and-mortar banks by using the power of the Internet.
Lending Club CEO Renaud Laplanche claims traditional banks have an expense ratio of 5% to 7% while his company has one below 2%. These low costs allow P2P companies to offer lower interest rates to borrowers, while simultaneously offering investors much higher returns than they would experience by simply parking their money in a bank (and having it lent out for them while banks reap the profits). This is the critical selling point of peer-to-peer. It is billed as a win-win for both borrowers and lenders. Clearly, this new model has several advantages for investors.
Easy to Invest
Investing in P2P loans is pretty easy. Prospective investors merely need to choose a service—Prosper, Lending Club and Sofi are the most popular—and sign up. From the comfort of their own home, investors can screen each loan they invest in, evaluating the quality of the borrower and determining how much risk they want to take. Investors that want to get started fast can hit the ground running on Lending Club by using their automated system which helps you invest based on your risk profile.
Compared to savings accounts, P2P lending offers attractive returns. The FDIC recently noted that the average savings account interest rate is a paltry 0.06%. Considering the rate of inflation is currently 0.5%, savers are actually losing money by storing it in banks. Compare that to the average 5% to 9% earned on Prosper and Lending Club during the past half-decade and the difference is clear. While investing in P2P loans will not be right for everyone, those numbers illustrate why so many people have begun entering this market.
The minimum investment on Prosper and Lending Club is only $25, making it affordable to lend to many different borrowers and achieve diversification at a relatively low cost. This helps minimize the risk that a default by an individual borrower, or even a class of borrowers, will lead to portfolio-crushing losses.
Moreover, P2P loans offer investors exposure to a different asset class. While the S&P 500 returned a mere 1% (including dividends) for 2015, P2P loans on average have consistently earned 5 times that amount or more.
Easy to Understand
Alternative investments like vintage wine and fine art have done very well over the past decade. Yet for many people, investing in these rarified assets is difficult. The entry costs are high, and the swings in value can be great. Investing in P2P loans is a much simpler proposition.
Traditionally, loaning money isn’t a particularly flexible investment. Once the money is lent, you need to wait for it to be paid back. If you needed the money immediately, well, you were out of luck. P2P loans are trying to change that. Secondary markets such as Foliofn allow investors to buy or sell their investments. The liquidity of these markets should continue improving as P2P investments grow in popularity.
Understand the Risks
While cutting out the bank is great for your profit margins, it also means taking more risk. Savings accounts at U.S. banks are insured by the FDIC to the tune of $250,000, meaning that if your bank goes bust, the government will reimburse losses up to that amount. P2P loans have no such guarantee. In fact, you are now subject to two types of risk—the risk that the borrower defaults, and the risk that the P2P service goes bust.
As with any investment, due diligence is necessary. Sophisticated investors and hedge funds have invested in P2P loans, meaning that your competition is not simply your retired neighbor. Moreover, investors in P2P loans are technically buying securities, not directly loaning money. Regulatory issues mean that investors usually have to meet certain income or net worth requirements, and certain states do not allow their residents to invest in P2P loans, putting this opportunity out of reach for some.
For the right investor, P2P loans might be be a fantastic opportunity. Those who do their research, invest carefully, and diversify their asset mix have made great profits on these services. While past performance is no guarantee of future returns, many believe that P2P lending will remain profitable for a long time. Indeed, PriceWaterhouseCoopers predicts P2P lending will grow to be a $150 billion industry by 2025. Considering the industry as a whole was worth $5.5 billion in 2014, that is fantastic potential growth. Investors who are tired of earning peanuts parking their money at banks should take notice.