Anyone who first hears about peer to peer lending and its amazing high-netting return potential is incredulous about all of its claims…I was…you were….everyone was! It just sounds like a scam.
After the initial skepticism was overcome (through research and a bit of trial and error) You got hooked but still found it hard to explain to others how it all works. How and why peer-to-peer lending platforms are capable of generating annual return rates between 8% and 10%….those numbers just sound too crazy to be true….
By now you know they aren’t fantasy as you managed to make a 8% return on one platform and 10% on some other…. With this post I will explain how exactly p2p lending platforms are capable of generating such high ROI for its lenders…
The rise of the internet and deregulation of traditional banking and lending were the enablers of a new alternative lending landscape that emerged at the turn of the century.
Basically there are different types of loan offerings for different type of needs. And we have to look at the different type of loan offerings to understand the high interest return rates being offered by peer to peer lending platforms.
Payday loans (are small money advances at a very high interest rates to be paid back when the borrower receives his next paycheck. Common interest annual percentage rates (APR) are in the 391-521% range!!!!!!
Most borrowers using payday loans have bad credit and low incomes and therefore may not have access to credit cards and are forced to use the service of a payday loan company. Payday loan providers therefore can charge exorbitant high interest rates which are calculated on a daily or weekly base e.g. $17.50 interest fee per $100 borrowed for seven days. Most loans are for 30 days or less with loan amounts usually between $100 to $1,500.
The borrower typically writes a post-dated personal check in the amount they wish to borrow plus a fee in exchange for money. The lender holds onto the check and cashes it on the agreed upon date, usually the borrower’s next payday. These loans are also called cash advance loans or check advance loans.
In the USA alone 12 million people use payday loans with a total borrowed amount of $7 billion.
Micro loans are a mission-driven form of finance aimed at small business owners who want to borrow $50,000 or less. The interest APR is commonly in the 8-22% range.
According to the Small Business Administration, its microloan program provides micro loans in order for businesses used “for working capital or the purchase of inventory, supplies, furniture, fixtures, machinery and/or equipment.”
In banking terms, a microloan is a very small loan ranging from $500 to $100,000. Historically, banks in the United States haven’t particularly liked dealing with microloans because they have not been profitable financial products for them to market. Other financing companies and institutions have filled this void.
Typical loans are for small business owners who want/need quick money and don’t mind paying a hefty fee in exchange for speed. Typical annual percentage rates range from 30-120%.
In its broadest sense, online lending is any kind of loan that’s not directly from a traditional bank and often online lenders are technology companies that use different methods to communicate with clients, base rates and approval on metrics other than your FICO credit score and similar traditional measurements and apply a different (frequently streamlined or automated) approval process compared to traditional lenders. This enables them to provide loans super quickly when money is needed by a borrower.
p2p lending marketplaces arose in 2005 by combining the alternative finance services as described above with crowdfunding. Basically peer to peer platforms cut out the middleman aka the payday/micro/online loan provider by bringing borrowers and lenders directly together through their platform/marketplace.
By doing this p2p lenders don’t need to have money at hand themselves which greatly reduces their costs. Their core competence is the platform technology and loan approval automation. By charging small fees (typically around 1%) they can create a highly profitable business that is beneficial for them, the borrower and lender.
The borrower can find loans with lower APR’s and the lender can get higher ROI on his investments in this new peer to peer lending model. Win-win-win for all three parties.
The high return rates investors can make on p2p lending platforms are understandable if you look at the loan services they compete with. Payday loans, micro loans, online loans all charge super high annual percentage rates to their borrowers. p2eer to peer lendng platforms offer these loans too but at much lower percentages due to their low cost structure. In that light a payday borrower loaning money at say 30% interest on a p2p platform is not strange at all as he would pay a multitude of that through a traditional (payday) loan institution. And an accompanying ROI of 20%+ for lenders/investors is a logical consequence thereof. Just very sound business principles at work here.
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