Peer-to-peer lending, or most-commonly known as P2P lending, is a financing method that matches individuals and businesses who need to borrow money with others who want to invest their money without the need for any financial institution as an intermediary at an agreed fixed interest rate.
The main idea and attractiveness of this practice is that investors get higher returns by lending their money rather than saving it; and borrowers get funds at a lower rate than traditional financing methods.
The entire process is conducted online through a number of peer to- peer lending sites or platforms. The basic function of the peer-to-peer lending sites is to connect borrowers with willing lenders.
In addition, the peer-to-peer lending sites perform all the credit and background checks on the potential borrowers in a pre-qualification process; and when approved, all borrowers are presented to investors to choose from.
The pre-qualification process differs from one site to another, but they are generally based on the borrower’s credit score, income, work history, and education. Peer-to-peer lending sites usually charge the investor an investor’s fee in the range of 1% of the amount borrowed and the borrowers an origination fee of 1%-5% depending on their credit rating.
By investing in peer-to-peer platforms, an individual basically offers his/her money for people to borrow. Peer-to-peer investing can be a rewarding investment as investors usually earn higher returns than the saving accounts offer.
However, as any form of investment, P2P investing comes with its own risks in the form of loan defaults; yet, these risks can be mitigated by the investor through perfectly crafting a mixed portfolio of borrowers.
Therefore, due to the current ultra-low interest rates offered on saving accounts, P2P investing is considered to be a remarkable investment.
One of the biggest threats that faces your investment portfolio is the volatility associated with its components as it can destroy your profitability in the short term. Therefore, it is important to diversify the investments in our portfolios with assets that are de-correlated because when volatility increases and the markets correct, your portfolios will remain fairly dignified.
For that reason, adding investment in bonds to investment in stocks is a shrewd strategy. Although bonds tend to give lower returns, their volatility is much lower and their returns can be considered fairly guaranteed.
To further reduce your portfolio’s exposure to volatility, an investment in peer to peer lending can help in achieving that goal, as has historically been the case of fixed income or gold; albeit investing in peer to peer business loans can give higher returns than fixed income with even lower volatility.
When comparing P2P lending vs the stock market, although they offer less liquidity, their returns are higher and volatility is lower.
Being considered an independent performer; together with its low volatility, demonstrate an almost total de-correlation of peer to peer lending with the rest of the market; including stocks and bonds. This makes P2P lending a perfect fit in your investments’ portfolio with stocks and bonds.
When comparing bonds vs P2P loans, it is agreed that bonds represent one of the most solid forms of fixed income investment; however, their yields are not on the highest end. On the other hand, P2P lending are still considered a low risk investment and offers more diversification opportunities and higher rates.
On the other hand, when comparing lending club vs stock market, the former is considered as both a stock and a bond as you can either invest in the company’s stock itself or invest in a portfolio of its peer to peer loans.
In conclusion, investing in P2P loans offers a lot of advantages; including:
Comparing P2P investing with other forms of financial investing highlights the benefits of the former and why it should be considered by every income investor.
First, when looking at the dividend yields, although they are considered to be one of the least risky forms of investment, it tends to offer less returns than stocks and P2P investing.
When investing with one of the most established P2P platforms, the average P2P lending return is in the range of 8%-9% versus an average dividend yield of 6%-7% on well performing stocks.
However, the main advantage of dividend yields over P2P investing is that the former is a form of long-term investment with a potentially increasing return while the latter is a short-term investment with a fixed return.
While P2P lending offer higher returns, they also expose the investor to higher risks.
With P2P lending investing, the investor invests in a relatively unknown borrower who might default on the loan versus a well-established corporation as with the dividend yields.
Due to the decorrelation between P2P lending investment and both stock and bonds, it is often advised to invest as much as 20% of your investment portfolio in peer to peer lending. However, and depending on the size of your portfolio, 10% investment in peer to peer lending is considered to be the minimum.
As with all forms of online dealings, investing in P2P lending means that you do not actually know who you are dealing with. This idea deters a lot of people from investing their own money in Peer-to-Peer lending.
However, with certain strategies of how to invest in P2P lending, this risk can be highly mitigated.
First, there are certain borrower’s credit rating criteria that an investor should focus on; such as: home ownership and stable job which reflect stability and dependability; and debt to income ratio, high income and no credit inquiries which reflect their financial soundness.
Second, by diversifying the loans’ portfolio over different credit grades and of different amounts, the investor will diversify his sources of return and lower the risk of defaulting from one of them.
Younger people tend to take more risks as they think they still got many opportunities ahead; however, as people get older, their tendency of taking risks becomes lower as losing your savings at an advanced age is a big problem. Consequently, people are advised to invest their money when they’re young, and then shift to protecting their savings as they grow older.
These trends draw young people more towards investing in stocks and stock market, but as they grow older their investment preferences shift to a safer form of investment. This is where P2P investing fits as it is considered both a good and safe investment with low risk. So if older people are planning to save for their retirement, they are advised to invest in P2P lending.
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