What is P2P Lending?
P2P lending is one of the fastest growing and yet most overlooked opportunities in today’s investment marketplace. The sector has grown out of a market need for easier and cheaper access to borrowing in the face of a generally tightening credit market.
Banks are less willing to lend money to individuals and small businesses, and when they do the interest rates charged can be pretty high and limiting. So borrowers who find it hard to get access to cash have created a market for cheaper borrowing away from the traditional routes of banking and finance companies.
For investors like me, the lower returns seen over the last few years from recognised investment assets have given a fillip to seeking alternative investment with better potential.
P2P lending is a relatively new innovation that matches investors with borrowers, and thus cutting out the traditional middleman that is the bank. Its development and growth has been promoted by the decreasing size of the world in today’s internet led society.
In a nutshell, the ethos behind P2P lending is to give access to cash for borrowers at cheaper rates, whilst giving better rates of return to investors.
How P2P lending works
If you want to invest in a P2P lender, such as Lending Club, America’s largest P2P lending business, you would buy investments notes. These are fixed income investments which pay you interest, usually on a monthly basis. It’s also common for these notes to pay back a portion of your capital invested.
The notes will be offered in different risk ranges, which reflect the risk of default by the end borrower. So you can select a better rate of return, but you’ll be invetsing in a riskier investment.
What’s the risk and reward comparison?
Obviously the higher the risk of default, the higher the potential return you’ll receive. But unlike other investments, such as stock purchases, you’ll be able to see the actual potential return you’ll get. This is because the interest on the money loaned out is set at the beginning of the term.
Other assets, such as stocks, commodities, even property, can only estimate potential returns based upon history: and we all know that historic performance is no guarantee of future performance.
So you know the potential return, but there is still the risk of default by the borrower. To lessen this risk, most P2P investors put their money in notes across a wide range of risk categories. For example, Lending Club has seven grades of loan risk, from grade A to G, with grade G notes being the most risky but producing a current annualized return of 12.07% (according to Lending Club). That’s a pretty good rate of return.
By investing across the range of loan grades, you’ll be diversifying: it’s a bit like buying shares of a whole range of companies.
The Bottom Line
P2P lending doesn’t have the long record that other investments assets have. It’s so new that this might put off many investors. But the P2P companies credit rate borrowers just like banks do, so this should help alleviate a great deal of that risk. Indeed, some of the companies in this space lend to only around 10% of loan applicants.
The way that the investment notes are graded makes it easy to compare high and low risk, and I like the fact that returns are directly linked to this risk. By spreading an investment across a number of investment notes, I can diversify my risk and can build a lending portfolio to augment my traditional investment portfolio. P2P lending could, one day, become an investment asset class in its own right.
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