According to the Wikipedia definition, this is the practice of borrowing funds for individual borrowers or businesses through an online platform that directly connects them with lenders.
Companies providing such peer-to-peer loans work entirely online, with their lower operating costs allowing them to borrow money - very often at a far lower price than traditional financial institutions.
Thus, borrowers benefit from lower interest rates, and lenders achieve higher returns on their capital than other savings products.
The service providers (P2P lending platform) receive a percentage of the loan amount against their brokerage services. Their function is in practice to meet potential borrowers and lenders.
Most of these P2P loans are unsecured loans, most of which are aimed at business.
Interest rates on loans are often determined by lenders based on the reverse auctions model or the lowest interest rate on which they lent their funds. Another way may be based on a fixed interest rate, depending on the credit scorer's credit rating.
On some peer-to-peer lending platforms, in order to reduce the risk and volume of bad loans, creditors themselves decide whether to allocate funds to a borrower or not.
How has the business started?
After the end of the financial crisis, borrowers began to look for lower interest rates and access to credit. On the other hand, lenders were looking for a higher return on their investment. Banks, struggling with tight regulation, have encountered serious obstacles to meeting the growing market needs.
This created a serious vacuum in peer-to-peer lending, filled with P2P platforms. They are characterized by a lower level of regulation because they are intermediaries in the relationship between creditors and borrowers.
The peer-to-peer lending industry has seen significant growth, especially in developed countries with advanced financial markets. In the United States, these platforms have been granted 6.6 billion credits, or 128% growth over the past year, with the country's largest volume market.
In terms of the amount of single credit granted, however, the United Kingdom is ahead of the United States, with the size of 72% larger. Experts believe that Europe is the next region in which this type of lending will experience a real boom.
Alternative financial markets on the Old Continent reached a volume of nearly € 3 billion in 2014, an increase of 144% on an annual basis, according to the same Business Insider survey.
In France, for example, the small market for P2P-lending has grown by 4,000% in the past year to € 8,2 million. This type of peer-to-peer lending is already gaining momentum in countries such as Germany, Sweden and the Netherlands.
How can I make money with peer-to-peer loans?
With peer-to-peer credit, you become a bank yourself and lend money to private individuals. Moreover, because you are not doing this out of pure charity, you are getting interest from the borrower. P2P platforms take over the brokering and merging of financiers and borrowers on the Internet.
In addition, the P2P credit platforms carry out a credit assessment of borrowers and their financing projects. The platform makes the result available to investors in a so-called credit score.
P2P loans offer investors high flexibility
Based on this score and your personal assessment of the borrower (the borrower presents himself and his financing project anonymized on the platform), you can make a decision for or against the investment. You can also decide on:
- The desired investment amount.
- The term of the investment
- Country (some platforms also offer foreign investment projects)
- The distribution of smaller amounts on several loan applications
As a result, investing in peer-to-peer loans is much more individual and flexible than traditional forms of investment with their often-long maturities and rigid terms.
The peer-to-peer loan doesn't work without a bank
All P2P platforms cooperate with a bank because it is regulated by law that only a credit institution with a full bank license is allowed to carry out banking transactions. The partner bank in the peer-to-peer loan is responsible for the transfer of money between the lender and the borrower.
As a rule, the bank charges for this a small percentage of the loan amount as a fee paid by the borrower.
What is the yield on peer-to-peer loans?
P2P credit platforms promise partial returns above 10%. Do not let it dazzle you. Experience shows that many investors have P2P loans in your portfolio that fail. This reduces the realistically expected return for investors to approximately 4 to 6%.
However, interest rates in P2P lending are still significantly higher than the return on traditional forms of investment.
We are still in a low interest rate phase. This benefits all those who borrow money, for example, to conclude a building financing or to take out a car loan. For investors, on the other hand, these are not good times.
Most traditional forms of investment, such as daily money or fixed time money, are still below the inflation rate in return. That is, while your money is in the account, it loses its value. Investing in P2P loans can thus be a lucrative alternative to traditional low-interest investments.
Advantages and disadvantages of P2P lending
- High returns.
- Flexible maturities.
- Investment amount starting from 10 € is possible
- Possible investment in a large number of loans.
- Largely transparent and self-selectable portfolio.
- Individually controllable.
- Default risk.
- Erroneous assessment of the borrower's creditworthiness.
- Insolvency of the P2P platform.
P2P Platforms: How to Invest in P2P Loans
Step 1: Select a peer-to-peer platform
First, select a P2P platform on which you want to make your investment. Criteria by which you choose or against a platform can be:
- Year of creation: Be careful with young companies. Platforms that have been on the mark for a long time are usually more trustworthy.
- Insolvency of the P2P platform
- Headquarters: Platforms from Europe have the advantage that communication is easier in the event of a bankruptcy of the platform during judicial disputes.
- Investment Amount and Term: Check how much the investment amount is on the platform and what maturities are offered. Low investment amounts and short maturities enable high diversification and are therefore less risky.
- Platform Fees: Check if the platform charges fees for arranging a suitable loan application, some peer-to-peer credit platforms do so.
If you have chosen a platform, register online. To do so, follow the instructions of the respective website. Here is a complete list of all the platforms.
Step 2: Select a P2P financing project
In the second step, select a project you want to invest in. The platform provides you with information on the individual loan requests: the person of the borrower about the project to be financed and — most importantly — the creditworthiness of the debtor.
Based on several hundred factors, including information from credit valuers, the platform creates an individual credit score for each loan application. This will give you guidance on how much the probability that a borrower will repay the money as expected.
The expected return is also based on the credit quality class. Good creditworthiness means low return prospects, but the risk of default is also low. A low credit rating, on the other hand, carries a high risk for your investment, but the expected return is also high.
Automatically invest through the P2P platform as an alternative to manually selecting investment projects, you can choose the automatic distribution of your capital by a portfolio manager on most platforms. The latter assigns your money to one or more credits.
To do this, you deposit once how much risk you want to take and how high the investment per loan should be at least and maximum. You can also decide whether you want to refinance your profits.
Step 3: Disburse your return
The disbursement of your return will be based on the platform you wish (that is, if you want to end your investment) or along with the capital used. If you want your money back before the end of the loan term, you can usually sell the loan to another lender for a small fee.
Failure Risk: What happens if a peer-to-peer loan fails?
So is Peer to Peer lending safe?. The P2P platforms promise some measures to mitigate the risk. In a first step, the platform will contact the debtor and try to find out why he did not pay. If this does not work, a reminder is issued by the intermediary partner bank. If the debtor still does not pay, the termination of the loan as well as the efforts of a collection agency follows.
The collection procedure is between the bank and the borrower. As an investor, you have no opportunity to contact the defaulting debtor, he remains anonymous. However, many platforms offer good transparency as to what stage the collection process is currently in progress, so that you can find out what your money is going on.
Particularly in view of the fact that P2P loans are mainly used by borrowers who have little or no chances in the traditional credit market, the risk of default in P2P lending must not be underestimated.
What is the buy-back guarantee for peer-to-peer loans?
Some P2P platforms, such as FastInvest, offer a so-called buy-back guarantee. This promises to buy back delayed loans and interest accrued up to then from the defaulting debtor, so that the creditor is relieved.
However, as an investor, you must be aware that such a buy-back guarantee can also be cancelled. If credit losses accumulate on a platform, it can only cover it up to a certain point. After all, even the platform cannot afford to buy unlimited debts.
What happens if a P2P platform goes bankrupt?
A second, big risk is the platform itself. If the platform goes bankrupt, your capital is also inevitably gone. Many P2P platforms are relatively young and not yet on the market for very long. This means that they have little equity and can quickly become victims of bankruptcies.
When the platform publishes financial reports or statistics on their growth, lending volume, investors and default rates on its website, you should track the figures to assess the risk of bankruptcy.
Top 3 tips for your peer-to-peer investment strategy
From the risk of credit loss and the risk of platform players, the most important rules for investing money in P2P loans are also derived:
- Scatter the risk: This means that you should never invest your capital in just one project. The best is high diversification with small amounts. If a loan fails, the loss will be worsenable by the relatively small sum.
- Do not put all the eggs in one basket: invest on several P2P platforms. If a platform fails, you will not lose all your capital.
- Be patient: Especially if you invest many small amounts as recommended, your investment needs time to develop. Give yourself this time and invest in a long and secure perspective rather than risk a lot in the short term.
The taxation of P2P interest income
There is still a pitfall that you absolutely need to know about peer-to-peer loans: Taking. Unlike, for example, stock profits, the withholding tax is not automatically withheld. As an investor, you are responsible for taxation of your profits from P2P loans and must prove the interest payments from each individual loan you have invested in.
Some platforms offer the compilation of all interest income as a service, while others require you to determine and sum up the income yourself.
When you decide to invest in peer-to-peer loans, you should always consider the risk of default. The amount of money you invest in P2P loans ultimately depends on your total assets. In general, we recommend investing only sums where you could lose a total loss.