Peer-to-Peer lending or simply P2P is a fast-growing asset class in the diverse world of finance and banking. While it’s not a completely new concept, its popularity has grown tremendously over the past decade mainly due to the many benefits it offers the market.
The simplest way to define P2P lending is that it’s kind of a marketplace where savers and borrowers meet and transact directly with one another. Usually, P2P platforms use proprietary algorithms akin to those used by dating sites to match people or businesses that want to lend to those that want to borrow loans. They also facilitate the secure transfer of money and help to track all the necessary records until money is paid back in full.
As you’d imagine, a lot more goes into the entire process including the risks involved; remember, we’re talking about unsecured or hardly regulated loans here. But as long as you understand what you’re getting into and are aware of all everything involved, you shouldn’t have a problem lending or borrowing P2P loans.
Here are five things you need to know about P2P lending and how you can avoid falling into common pitfalls.
This is arguably the most important thing you need to know before joining a P2P platform. Suppose you decide to do peer-to-peer lending at Crediful.com for example, and the person you lend to loses his job and defaults the loan. In such a scenario, you’ll likely lose your money while the defaulter messes up their credit rating.
This is probably something you won’t need to worry about when depositing money with a bank. This is because banks do not pass on their losses to clients and the reason they offer lower interest rates compared to P2P lending facilities.
If you’re getting into the P2P lending industry as an investor, you’ll be happy to know that there are a number of ways you can invest your money here. The most common strategy is the managed or automatic method that allows you to put your money into the platform and it does nearly everything else for you. Most platforms that support this method, however, allow you to make some personal choices including how much risk you’re ready to take, how long your money stays with them, and the returns you expect at the end of the lending period.
If the above approach doesn’t sound appealing to you, there’s the semi-manual method that gives you more control over your money and investment choices. Here, you’ll be allowed to make decisions on aspects like who to lend to, how much money to allocate to which borrower, etc.
Both of these options have their pros and cons and it’s upon you to weigh your options and choose what works best for you.
Different peer-to-peer lending platforms charge different fee rates mainly for facilitation and management. Obviously, you want to work with a company that charges the lowest fees, whether you are in it for loans or lending. In most cases, P2P platforms charge lenders what they refer to as management fees while others take a share of the money from the borrower before the withdrawal.
Be sure to conduct due diligence on your preferred company to understand their fee criteria as this can have a significant impact on how much returns or loan amount reaches you in the end.
A majority of P2P platforms lock your money for the entire loan repayment period which can range from 3-5 years. As such, you’ll have to prepare yourself for the long wait unless your preferred platform allows for early withdrawal as in the case of P2P lenders that support secondary markets. This means you can sell (or simply transfer) your loan to another person if you want to free up your money again.
We mentioned earlier that defaulting is part of what you can expect when using peer-to-peer lending facilities to make money. The good thing however is you can significantly cut down on this risk by using risk diversification strategies like fractionalization and risk grades when engaging borrowers.
Fractionalization is simply the process of spreading your money on several loans as opposed to funding one or a few of them. What this means is that if one defaults, you do not lose all your money. On the other hand, it’s important that you’re extremely careful with the borrower’s credit rating which shows how good or bad a prospective borrower is when it comes to paying off their debts. This will help you dodge serial defaulters or those at high risk of defaulting due to factors like inconsistent incomes or commitment to other lenders.
Have you used a P2P lending platform before? How was your experience? We’d love to hear your feedback.