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When it comes to investing, the smart money looks at the stock market – as well as outside of it. There is big money in alternative investments, like venture capital or other types of private equity. Alternative investments come with their own risks and requirements, but make the right move and it is not uncommon to double your investment within a few years. While you may be limited by whom you know (after all, the best deals may not be open to everyone), there is one type of private equity you should definitely keep on your radar – peer-to-peer investing.
Peer-to-peer is hot right now. “More than a dozen investment funds have been formed with the sole purpose of investing in peer-to-peer loans,” writes the New York Times. “P2P sites are also attracting some of Wall Street’s biggest names as board members and investors.”
Image via Flickr by photosteve101
What is Peer-to-Peer Investing?
Peer-to-peer (or P2P) investing is exactly what it sounds like: people invest in each other instead of using credit or going through a bank to get extra funding. It is part of what The Economist calls the “sharing economy”.
Payments are made on a schedule, usually monthly or at the end of the contract. While there are several types of P2P investing or P2PI, it is generally divided into two categories. The first is selling a renewable asset to peers. Opportunities in this space are relatively limited and, for the most part, you probably will not be able to live on this income alone, but it is a way to make some easy extra money as long as you do not mind risking damage to the asset. Examples include putting your apartment on AirBnB while you are on vacation or letting someone rent your car while you are away.
The second is peer-to-peer lending or P2PL, and it is much more common.
What is Peer-to-Peer Lending?
With peer-to-peer lending, loans are made from person to person instead of through a bank. The borrower pays a service like Lending Club or Prosper to find people who would be willing to loan him other money. Investors then see the loan amount, the reason for the loan, the person’s credit score, and the interest rate to which the borrower has agreed.
However, unlike a bank, any loans given are not absorbed by a single individual, but by several people at once. In this way, P2P investing is actually a type of “crowd-lending”.
Crowd-lending vs. Crowdfunding
Crowd-lending and crowdfunding are often used interchangeably, but the two are very different. Crowd-lending is strictly a for-profit activity. In contrast, “crowdfunding” involves many people funding an individual venture but does not require there to be a return on that investment, like donating money to a favorite cause on Kickstarter.
Is Crowd-lending Regulated?
Yes. According to the Federal Communications Commission (FCC), crowd-lending offerings “must be conducted through a registered broker-dealer or a newly-created class of ‘funding portals’ subject to new Section 4A(a) of the Securities Act which requires intermediaries involved in crowdfunding transactions to satisfy certain registration and other requirements and take certain steps to protect investors.”
Also, crowd-lending investors are limited by two cardinal rules:
- Investors are limited to investing more than $1 million in crowd-lending securities in any 12-month period.
- Individual investors are limited to how much they can invest in crowd-lending by their annual income or net worth. If either of these is less than $100,000, investors can invest the greater of 5 percent of their net worth, 5 percent of their annual income, or $2,000. Crowd-lending investors with an annual income in excess of $100,000 or a net worth equal to or greater than $100,000 are allowed to invest up to 10 percent of their net worth or 10 percent of their annual income.
Which Crowd-lending Portal is Best?
There is no best. Like any investment, there will be winners and losers, and the greater the risk, the greater your potential reward. There are three big crowd-lending portals: Lending Club, Prosper, and Patch of Land.
Lending Club is the largest crowd-lending portal. Since it started, the company has issued $13.4 billion in loans, and its investors have earned an average 7.6 percent return on their investments. Its rival Prosper has issued few loans – roughly $5 billion – but reports higher returns. The company says that its investors make around 8.9 percent, but they only count crowd-lending notes in that figures once they are older than ten months. Patch of Land is a much smaller portal. It has issued just over $65 million in loans since it began. However, it also boasts returns near 12 percent.
How are Borrowers Vetted?
Crowd-lending portals are geared toward borrowers with high credit scores. They gather financial information about their applicants and run credit checks – and they are very picky. According to the FCC, borrowers are generally required to have a credit score of 660 or higher and, even still, the rejection rate is high. Market leader Lending Club turns down roughly 90 percent of its loan applications.
Are There Other Factors to Consider?
Crowd-lending also has a narrative side. Borrowers are encouraged to tell their stories and explain what they will do with the loan. This is anecdotal, and, of course, borrowers could be stretching the truth, but this adds a social welfare aspect to those investments that many investors like. Also, many small business owners and sole proprietors turn to crowd-lending to finance a new or growing business. Hearing their stories may inspire you to invest in one borrower over another – for better or worse.
What are the Risks?
The individuals in which you would be investing are vetted through the crowd-lending portal, but there is still risk. Take Lending Club for example. Roughly 5 percent of its loans go into default. In 2014, the crowd-lending portal issued $3.5 billion in loans of this some $129 million were charged off and $70.9 million were paid late. If that happened to a loan in which you invested, you would lose the entire investment. That is not to say it will happen – again, only around 5 percent of its loans go into default – but investors should understand this risk going forward.
What Else Do I Need to Know?
Because there is so much institutional interest, crowd-lenders have purchase limits and speed limits to limit the involvement of these institutions and fund managers so that individuals can continue to participate. Even still, investors may find that they have to check crowd-funding portals often, The New York Times explains, “P2P loans that once took days or weeks to finance are snapped up in minutes, particularly those with higher yields.”
Also, keep in mind the risks that come from crowd-lending. Most investors are going to do better by investing small amounts in several crowd-lending loans instead of doubling down on a single borrower. This will help hedge some of the risk. In addition, remember that you have to pay to play. As loans are repaid, you will receive cash into an account held by the crowd-lending portal; make sure you are reinvesting this money for the best return on your investment.