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The right way to Spend money on Peer-to-Peer Lending

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If you’ve got the spare funds and want to explore nontraditional investing, peer-to-peer (P2P) lending might be worth considering. It allows individual investors to lend money to borrowers who are seeking loans. Risk is higher when compared to other investments, but that could potentially lead to better returns. Here’s how to start investing in peer-to-peer lending, along with the pros and cons of doing so.

How Investing in Peer-to-Peer Lending Works

Peer-to-peer lending is generally done through lending services platforms such as Prosper and Upstart, which connect investors directly to potential borrowers. They serve as the middleman and handle the logistics of the lending process. That often includes:

  • Finding creditworthy borrowers
  • Verifying their identity
  • Transferring funds
  • Collecting repayments

In some instances, loans might be funded by the platform or a third-party financial institution that sells the loans to investors. Either way, lenders typically have no direct contact with borrowers, and both parties’ identities are kept confidential. If all goes according to plan, borrowers will make good on their payments.

Should I Invest in Peer-to-Peer Lending?

Deciding to get started with P2P lending is a personal preference, and it’s important to weigh the benefits and risks before jumping in.

Benefits of P2P Lending

  • Potential for high returns: P2P lending could open the door for competitive returns. For loans issued by LendingClub from 2015 to 2018, the median rate of return ranged from 4.7% to 10.3% for creditworthy borrowers, according to the International Review of Economics and Finance. Prosper puts its average historical return at 5.7%.
  • Low barrier to entry: Peer-to-peer lending platforms may allow you to invest with as little as $5 to $25, though some platforms have higher requirements.
  • Diversification: Investing in peer-to-peer lending can help diversify your portfolio and mitigate risk. It’s an alternative investment that could be a nice addition to securities like stocks, bonds, mutual funds and exchange-traded funds (ETFs).

Risks of P2P Lending

  • Risk of default: Most P2P lending platforms vet borrowers, but it’s always possible to lose money. If a borrower defaults on a loan you funded, it could result in a significant loss. As with most high-return investments, gains are never guaranteed.
  • Fees can eat into your returns: Every platform is different, but most charge a servicing fee. For example, you may pay a 1% annual fee for every payment you receive from borrowers.
  • Funds are tied up in the platform: Once you fund a peer-to-peer loan, you’ll have to wait until it’s repaid to recoup your initial investment. That could pose a problem if something comes up and you need money sooner than expected.

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How to Invest in Peer-to-Peer Lending

If you’re looking to get started in P2P lending, follow these steps.

1. Choose a Platform

The right peer-to-peer lending platform will depend on your investment goals. For example, Kiva provides loans to underserved populations. Depending on your values, partnering with this type of platform could be a form of ESG investing. Meanwhile, some platforms may only work with accredited investors. That means:

  • You have a net worth of at least $1 million or
  • Your income exceeded $200,000 during each of the previous two years, or you had a combined income of $300,000 if you’re married

When comparing P2P platforms, clarify fees and investor requirements to decide which one is the best fit.

2. Create an Account

Each platform works a little differently, but you’ll likely set up an account and then decide which loans you want to fund. You can do this manually or set your preferences and have the platform match you to potential borrowers. Some platforms allow you to automatically invest in loans that meet your criteria.

3. Stay on Top of Your Loans

Watch your peer-to-peer lending account to ensure that borrowers are making on-time payments. If you work with a financial advisor, loop them in so they can monitor your investment performance. Depending on how it goes, they may suggest modifying your asset allocation to minimize overall risk. They can also help you identify your ideal borrower and loan amount, calculate your average P2P returns and see how it all fits into your long- and short-term financial goals.

Alternatives to Investing in Peer-to-Peer Lending

Peer-to-peer investing is just one option if you’re looking to get started with investing or to diversify your existing portfolio Some other options include:

  • Real estate investment trusts (REITS): With REITs, you’re investing in companies that own and operate income-producing properties. REITs trade on stock exchanges and are required to distribute at least 90% of their income through dividend payments. That could make sense for risk-averse investors who want to get into real estate.
  • Exchange-traded funds (ETFs) that target startups: Investing in individual startups can be risky as there’s no guarantee that they’ll be successful. Initial public offerings (IPOs) can also be difficult to access. ETFs that focus on startups can be a good alternative. They allow you to invest in young companies while staying diversified.
  • Hedge funds: These funds typically pool money from multiple high-net-worth investors. A fund manager makes investment decisions on behalf of the fund in an attempt to net higher-than-average returns. This often involves high-risk investment strategies. Hedge funds generally require a large investment.
  • Angel investing: This involves investing in startups or early-stage businesses that are just getting off the ground. In exchange, you’ll likely receive an equity stake in the company. Angel investors are also known to provide mentorship and business advice. Like all high-risk investments, returns aren’t guaranteed.

The Bottom Line

Investing in peer-to-peer lending isn’t for everyone. It’s possible to create a steady stream of returns—or suffer significant losses. Given the average rate of return, some investors may feel more comfortable investing in stocks. The average annual return for the stock market has been around 10% for the last century. The right investments for you will depend on your risk tolerance, goals and financial situation.

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