Peer-to-Peer Lending: 7 Things Investors Should Know

By Alert Investor Markets Fool.com

Peer-to-peer lending platforms connect individual investors with borrowers in need of financing. Image source: Getty Images.

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You've heard about matchmaking for romance, but what about matchmaking for loans? For about a decade, peer-to-peer lending platforms have essentially functioned as a matchmaking service for lenders and borrowers.

In the "peer-to-peer" lending world, while some of the lenders may be banks, many are individuals who invest in peer-to-peer loans through online peer-to-peer platforms offering a variety of loan options. In return for lending their money, investors are promised regular payments at a set interest rate.

The peer-to-peer, or P2P, lending industry has experienced significant growth since the first major P2P platforms were established in 2006 and 2007. The total amount of money lent through P2P platforms grew more than 80% a quarter from 2007 through 2014, according to research by theFederal Reserve Bank of Cleveland. And a separate report byPricewaterhouseCooperssees that growth continuing, with the volume of P2P loans in the U.S. projected to grow to $150 billion annually by 2025 from the $5.5 billion issued in 2014.

But just because an industry is growing, it doesn't mean there are no risks to investors. In fact, some argue that while investors may expect steady returns from lending money through peer-to-peer platforms, they should also be prepared to lose their entire investments.

"Investors are interested because yields on the P2P investments are higher than what they get in the bank (through savings accounts and CDs), but in exchange for those higher rates of return, they're being asked to take on higher risk," said Mitchell Weiss, a former chief executive of a commercial finance company and the founder of the Center for Personal Financial Responsibility at the University of Hartford.

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"This is not for the faint of heart," he said.

If you're considering lending through a peer-to-peer lending platform, here are seven things to keep in mind:

1. The type of loans you can choose to invest in vary widely.Such loans can include, for instance, "loans for borrowers to install energy-efficient features in their homes, or small business loans to start companies that integrate social responsibility into their business plans," the Pricewaterhouse Coopers report notes. They can also include student loans.

2. The higher the interest rate, the riskier the loan.Like banks, peer-to-peer lending platforms set higher interest rates for borrowers deemed to be less creditworthy based on traditional factors such as credit scores and credit histories. Unlike banks, as the Cleveland Fed notes, lending platforms may also use anything from SAT scores to type of employment to assess creditworthiness. Investors who choose to lend to less creditworthy borrowers can, in return, expect higher interest rates, but they also assume the risk that a borrower will be more likely to default on his or her loan, and the loans are generally graded "A" through "D," with "D" having the greatest probability of default, though specific grading scales may vary from platform to platform.

3. Major U.S. platforms don't guarantee loans.If a borrower defaults on a loan you've invested in, don't expect the P2P platform to dig into its own coffers to pay you back. While platforms do work to recover money from delinquent borrowers, the two largest U.S. platforms also note on their websites that loans are not insured or guaranteed, and that lenders may face negative returns.

4. You can invest in partial loans.Investors in P2P lending don't have to fund 100% of a loan. Rather, they can contribute a small amount of money -- one major P2P platform sets contribution minimums at $25 -- and these contributions are pooled with those of other investors to meet the borrower's needs. Investing in a number of partial loans can also help you diversify your risk, so you don't have all your money tied up with one borrower. Read on for more on this subject.

5. Diversification helps mitigate risk...if you can afford it.As with investing in general, diversifying your lending investments can help reduce, though not eliminate, risk. Major P2P lending platforms allow investors to pick from a variety of loans manually -- that is, to scroll through the various options themselves -- or to take advantage of tools that pick loans based on criteria listed by the investor. But the amount of money it takes to achieve a healthy amount of diversification may be too high for some investors. One P2P proponent, Simon Cunningham of LendingMemo, recommends spending $2,000 to invest in 80 loans, but Cunningham admits on his site that that's unpalatable for many people, especially when it comes to a new investment.

"Most people don't try anything new with $2,000," he wrote last year. "What parent gives their middle schooler a $2,000 saxophone on the first day of band class?"

6. Be aware of fees.The revenue that P2P platforms depend upon comes from fees charged to both borrowers and investors. For investors, those fees include servicing fees and, in the case of delinquent loans, collection fees to pay the platform for its efforts to recover money. Such fees are typically disclosed on the platform's website, though where those disclosures exist may vary from platform to platform.

7. It's unclear what will happen to P2P loans during a major downturn.This, perhaps, is the biggest concern for P2P critics. Because peer-to-peer lending is still relatively new, it's difficult to gauge how well the loans will perform during a recession. The historical performance data that P2P lenders provide to investors largely dates back to after the Great Recession of 2008.

"They have no access to how these borrowers will actually perform when the market is stressed," Weiss said. "That's the great uncertainty with all of this."

Peer-to-peer lending platforms are regulated. The regulator charged with overseeing a specific platform may vary, but investors seeking help may contact theSecurities and Exchange Commissionor theirstate securities regulators, either of which will make sure their requests are referred to the proper agency.

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