(for further reading, Lend Academy is a premier P2P information site)
In its basic form, from an investor standpoint, we are providing money to regular people who have applied for personal loans for various purposes (such as debt consolidation and refinancing). The people pay back those loans, with interest, and a portion of that interest is paid back to you monthly which is how you make money. In a way, you become their bank for the loan. While P2P lending advertises returns in the 5-8% range, there are risks like with any investment. For example, the company charges you as the investor a small fee which lowers your real return. It is also important to note that the interest you are paid back, for tax purposes, is treated as ordinary income and taxed at a higher rate. So if possible, your account may be better suited to be placed in an IRA (instead of a taxable account).
Additionally, the loans are unsecured meaning they can default somewhat easier than a traditional loan. While P2P lending companies say they follow standard debt recovery procedures, it is hard to say what this means for the average investor. There is also the chance that the P2P lending company goes out of business but again there are protections in place for the investor to try and recover at least some of their investment back.
As an investor, you are also advised to spread your money around and fund a large number of loans. The minimum amount you can put into a loan is $25. Similar to diversification with stocks, spreading your money around to different loans minimizes the risk if/when a couple of those loans go into default and stop paying. Loans are broken up into different risk propositions by the company’s underwriters and obviously the less risky the loan is perceived to be, the less return and vice versa.
There are a number of companies in the P2P lending business but for now, I’m sticking with the major player in the industry: Lending Club. My plan is to fund a mixture of high risk and low risk loans (with a lean towards low risk until I get more comfortable). You can follow my adventures with P2P (Peer-to-Peer) Lending if you’re interested in learning more.
Receive a $75 investing bonus for signing up at Lending Club!
Playlist of video reviews for my P2P (Peer-to-Peer) Lending Adventures with Lending Club