Peer-to-peer lending (also known as P2P lending) has gone from a hot fintech trend a few years ago to a popular and legitimate way for investors to earn a stream of income today.

As this type of lending gains popularity because of its relatively high expected returns and low-cost entrance into the market (an investor can start with as little as $25), we look at what P2P lending is, and examine some of the possible risks and rewards.

What is P2P Lending?

P2P lending leverages different types of technology – from online payment and investing capabilities, to Big Data that predicts the likelihood of loan repayment to create interest rates. It then anonymously matches investors with borrowers via online services based on factors, such as risk/reward, interest rate/return, credit report, debt-to-income ratio, and type of loan (personal, small business or refinance).

For example, a borrower can request a loan for $2,000. An investor would lend a portion of that amount – this could be any amount, from as little as $25 to the full amount. Certain states have limitations on the amount that you may invest, but under no circumstances can you purchase notes in excess of 10% of your net worth (exclusive of the value of your home, home furnishings, and automobile). 

If you decide to only put up a portion of the loan, then you would share that loan with other investors. This is where diversification comes in; the more you spread out your investments among many loans, the lower your risk from a single default.

By eliminating overhead costs like physical branches, P2P platforms can lower costs for investors.

P2P History and Projected Growth

Born from the financial crisis of 2008 and the resulting banks’ tightening of lending standards, P2P lending is a way to create personal loans that Big Banks either won’t finance or will charge more for. It also gives some investors the chance to capitalize on high interest rates. By eliminating overhead costs like physical branches, P2P platforms can lower costs for investors.

How Money Is Earned

Most P2P companies earn their money two ways: 1) They tack on origination fees to the borrowers’ loans, and 2) They take a portion of the loan repayments made to investors.

P2P loans are unsecured and typically range from $1,000 to $40,000 (bigger loans are available for businesses and lines of credit) and the APR can be anywhere from 5.32% and 36%, according to Prosper and Lending Club, two of the largest and most popular P2P platforms.

The average loan tends to be for 30-to-60 months. According to statistic site NSR Invest, for the first three quarters of 2016, the average investor ROI for Lending Club loans was 5.96%, while the APR for borrowers was about 13.46%, and the average loss was about 6.70%. This data comes from 434,407 loans with a total amount of $6,400,541,700.

Some Pros & Cons of P2P Lending

Pros

• Opening a taxable account online is easy and inexpensive; initial investments start at $25
• Diversifying risk is possible and wide-ranging as investors can fund hundreds of loans with varying loan grades
• Higher average returns than bank CDs, but potentially with more risk
• Potential to collect monthly income via repayments and interest from borrowers

Cons

• Interest is taxed as ordinary income, making P2P tax inefficient if used in a taxable account
• Opening IRA accounts requires a third-party custodian and is a bit more work and cost to set up
• High-risk loans with high interest rates can be risky in a recessionary environment
• P2P platforms can default and even be entangled in fraudulent practices by borrowers, such as identity theft, fake bank accounts, fake businesses and loan stacking, all of which puts your money at risk
• You are committed to the terms of the loan – some loans have a secondary market but you can expect to take a big discount if you want to sell early

Exercise Caution with P2P Lending

Historically, the returns have been in the high single digits, 7%-to-9% range. But investors should be cautiously optimistic about P2P lending. It’s important to keep in mind that P2P lending hasn’t been around long. There are two things to consider here:

1. P2P lending is thriving during a period when the economy has been good, so there’s not that much consumer default. Default rates will likely rise if the economy softens.
2. It’s a new piece of the market, so there’s less competition amongst each other.

So, people should expect positive returns over time, but not necessarily every year and not as high as we’ve seen the last several years.