Peer-to-Peer Lending: The Ultimate Guide
Last updated on 24 March 2021 by Reza
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Interested in P2P loans?
Peer-to-peer loans (P2P) are one form of crowdfunding. More precisely, crowd lending.
Crowdfunding is also referred to as swarm fundraising, where several small investors finance a single venture.
The following topics will be examined in more detail.
The term crowdfunding has become an increasingly common term in the media as well as day-to-day life.
Often, for example, start-up companies obtain financing through crowdfunding. There are also municipalities and associations that use crowdfunding to carry out their projects.
What is crowdfunding?
The purpose of crowdfunding is to raise money from many different investors to finance a project.
The term is derived from the word "crowd" for quantity and "funding" for financing.
In commercial crowdfunding, it can be further divided into crowdinvesting and crowdlending.
A non-commercial form of crowdfunding also exists, namely donation crowdfunding. In principle, these are donations for a specific project.
A brief history of Crowdfunding
Individual groups joining together to finance certain activities is by no means a new phenomenon.
Looking at the past, the Statue of Liberty in New York, for example, was partially financed by crowdfunding. The statue itself was a gift from France. But the base on which the statue was to be placed had to be financed by the US.
This was only possible through a fundraising effort in which a large number of people contributed a substantial amount of money to finance the base.
The Internet made it possible to bring the idea of crowdfunding to a far greater number of people.
As a result, the crowdfunding platform Kickstarter was founded in the US in 2009. A number of very successful projects followed, which helped crowdfunding achieve a breakthrough.
Today numerous crowdfunding platforms exist in the US and in other countries.
Among the best-known platforms in the US are GoFundMe, LendingClub and Prosper.
This form of crowdfunding allows investors to acquire a share in the respective project. For instance, if a new company is financed, the investor acquires a direct share in that company.
This is why crowd investing is referred to as equity financing.
Crowdlending (peer-to-peer crowdlending)
Crowdlending is another way of bringing investors together to finance a project. Unlike crowdinvesting, which is a loan with a fixed term, crowdlending is a loan with a fixed maturity.
Consequently, crowdlending is a form of debt financing.
P2P loans are a common form of crowdlending. A distinction is sometimes made between P2P consumer lending and P2P business lending.
P2P business lending is often referred to as crowdlending.
A look at the most popular P2P platforms reveals that the term P2P credits has become generally accepted.
Crowdinvesting vs. crowdlending
The terms crowdinvesting and crowdlending are often used interchangeably.
Crowdinvesting is a form of equity investment. This means that you are acquiring a similar share in a company as you would with a stock. The only difference is that this share is not traded on the stock exchange.
When you engage in crowdlending for a project, you are granting a debt participation to the respective borrower.
Equity investments tend to carry a much higher risk than debt investments.
Meaning of peer-to-peer (P2P) lending definition
Peer-to-peer loans are enjoying increasing popularity.
Most people have a rough idea of what P2P lending is, but cannot describe exactly what defines a P2P loan.
P2P lending: What is P2P lending?
In the case of peer-to-peer (user-to-user) lending, a user borrows money from other users. A P2P platform brings these users together.
These users may be private individuals, companies and public institutions. Users can act as investors and also as borrowers.
A particular feature of P2P lending is the fact that there is no middleman who acts as a central point for accepting deposits and granting loans. This role is normally assumed by the banks.
P2P lending is sometimes referred to as Social or Crowdlending.
How does P2P lending work?
Similar to a bank, P2P loans must be evaluated. This is known as a credit check (credit assessment).
This function is fulfilled by the respective platforms. There are differences in how the individual platforms assess the creditworthiness of a loan (or borrower) depending on the individual platform.
The result, however, is that the platforms always assign ratings (scores) for the respective loan. In the US, this score is assessed by 3 credit bureaus (TransUnion, Experian and Equifax) and ranges from 300 - 850.
The better the score, the lower the risk for the investor.
After the rating is assigned, the loan is offered to users on the platform. The interest rate is based on the assigned rating.
The higher the risk, the higher the interest rate.
P2P loan types
It depends on the respective platform why the P2P loans are taken out.
There are platforms that exclusively grant consumer loans from one private individual to another. Other platforms offer their investors a wide range of credit types they can invest in.
The most common types of P2P loans include
- Consumer credit
- Car loans
- Real estate loans
- Corporate loans
Currently (as of December 2020), the majority of the loans offered are consumer loans.
Return on peer-to-peer lending
Especially savers are looking for alternatives to invest their money in the current low-interest environment.
With some exceptions, the interest on overnight money is no longer paid, and in the case of fixed-term deposits, interest is only paid at all against relatively long maturities.
P2P loans with short maturities of 3 to 12 months offer investors average yields of over 5%.
Particularly high returns on risky P2P loans
Almost all peer-to-peer credit platforms provide a rating. A rating is an assessment of how risky the respective loan is.
In general, the worse the rating, the higher the return.
But not only the rating is decisive in this situation.
As a result, you are likely to receive a higher return on corporate loans, subordinated loans and real estate loans, as these types of loans carry on average a much higher risk than consumer loans.
A consumer loan with a poor rating will likely offer you a lower return than a comparable corporate loan.
Calculating return on P2P loans
When you start investing in P2P loans, you often invest in many small loans.
This corresponds to the original idea of crowdlending.
These loans will have different maturities and interest rates.
Once you invest your money across 2-3 credit platforms, it becomes difficult to calculate the total return.
Every platform calculates the achieved return a little differently.
This means that you cannot simply calculate a (weighted) average return across all platforms.
The only way to obtain a valid result is with the internal rate of return method.
This would be very tedious (impossible) to do manually, so we recommend that you use Excel or a similar program.
Be sure to utilize the XINTZINSFUSS function in Excel, because this function considers payments at different times.
Risks of peer-to-peer lending
There are some risks to consider when investing in P2P loans.
Peer-to-peer loans range from risky to very risky. You are lending to private individuals or companies. This means that you have to expect a total loss, similar to other risky asset classes.
When banks grant loans, they always try to assess the risk of not being able to recover their money. If a loan defaults, the bank is immediately affected. The amount must be written off and reduces the bank's profit.
P2P platforms, on the other hand, merely procure the loans.
The borrower is charged a fee for this service. If a loan defaults, the investors are liable for it.
In addition to the usual risk of loan default, P2P loans require you to consider the other asset class specific risks.
Risk of default
The risk of default is the primary risk when granting loans.
If the borrower can no longer make his payments, a solution will have to be sought first. If it then becomes apparent that repayment can no longer be expected, the loan is written off.
Foreign currency risk
If you plan to invest in loans in foreign currencies, you must be aware of the foreign exchange risk.
Foreign currencies may appreciate or depreciate significantly. This could severely affect the value of your investments.
P2P platform insolvency
If a P2P platform you invested your money in goes bankrupt, you could face serious consequences.
There is a risk of total loss of your investment in the platform.
In bankruptcy proceedings, the respective creditors, to which you also belong, would have to be satisfied first.
If there are creditors, such as banks, that are satisfied first and then there is nothing left, you will lose any capital you have with the provider.
Insolvency of the loan originator (loan intermediary)
P2P loan platforms grant loans differently.
Certain platforms provide loans directly from users to other users. Others work in cooperation with so-called loan initiators. These are loan intermediaries who refer borrowers to the P2P loan platforms.
For example, Mintos, one of the larger European P2P lending platforms, works with loan originators.
The effects that the bankruptcy of credit initiators can have were demonstrated by Eurocent in 2017 and Aforti Finance in 2019.
When a loan broker goes bankrupt, you are faced with the threat of total loss of your assets through this loan intermediary.
For the moment, investors no longer have access to their money, which was allocated via Eurocent and Aforti.
How secure are P2P loans?
Peer-to-peer loans are risky to very risky investments.
It is also considered to be a very recent asset class.
The historical figures needed to make a reliable risk categorization are simply not available.
Additionally, different types of loans are granted in different countries by the respective platforms. For example, individual platforms grant loans in Indonesia or Vietnam.
The diversity of the platforms makes it very difficult to make general statements about the risk/return profile of these asset classes.
Is there deposit insurance for P2P loans?
Unlike bank investments, peer-to-peer investments are not covered by FDIC insurance. That means you will not be reimbursed in the event of borrower default.
P2P lending crisis 2020 (Corona crisis)
Peer-to-peer loans are a new investment class. Therefore many critics were anxious to see how this investment class would perform during a crisis. The Corona crisis provided the necessary challenge.
Since P2P lending platforms differ greatly from one another, it is very difficult to make a general statement.
Nevertheless, it could be observed on almost all platforms that the total volume of loans issued fell enormously in the Spring. In this context, lending rates also increased considerably.
This development occurred as many investors stopped investing in loans and the creditworthiness of loan seekers also deteriorated due to the crisis.
Delays in disbursements also occurred on some platforms, as many investors wanted to withdraw their money at the same time.
However, a big crash, which many P2P critics have been predicting for years, did not happen.
Grupeer Scam in 2020
Although most P2P platforms worldwide were able to hold their own during the Corona crisis, a well-known European platform experienced a spectacular breakdown.
The platform Grupeer had to file for bankruptcy. The platform cited the Corona crisis as the main reason.
Investors have been waiting and fearing for their money to this day.
It is assumed that they will not see their money again.
At present (as of December 2020), however, it is not clear whether the corona crisis is the real reason for this development. There are some crazy rumors circulating on the Internet, and it is assumed that fraud has been committed.
Peer-to-peer lending sites and companies
The best-known platforms worldwide include LendingClub and Prosper based in the US.
In Great Britain, Zopa is particularly widespread. Zopa was the first P2P platform in the world.
In Europe, the Baltic P2P platforms Mintos and Bondora have a particularly large share of the overall market.
The Baltic countries have a vibrant P2P community and the local banking market makes it very easy for P2P platforms to gain market share.
What distinguishes the best P2P lending platforms?
Because you are always subjected to platform specific risks as a P2P investor, you should generally invest in the platforms that offer the best value.
The best P2P platforms fulfill all or almost all of the criteria mentioned above:
- On the market for at least 3 years
- The highest possible transparency
- Attractive ratio of return to risk
- Automatic investment function
- A large number of loans with different credit ratings and maturities
- Officially regulated by the banking supervisory authority or similar
Investing in peer-to-peer (P2P) lending
Investing in P2P loans is very easy. All you need is a little bit of capital and you need to legitimize yourself on the respective platform.
The majority of the platforms use VideoIdent or another video method, with which you can legitimize yourself in a very short time with your identification documents.
Due to the specific platform risk in this investment class, we recommend investing your money across at least three platforms.
Each platform features its own user interface. Normally, you can filter the loans by various maturities, risk classes (ratings) and loan types.
This allows you to select every single loan in which you want to invest your money.
As a rule, we recommend that you diversify your investments as much as possible.
These platforms deliberately offer low minimum investments per loan in order to enable investors to reduce their individual credit risk.
But this can quickly become very tedious, for example if you want to distribute $ 500 across 50 loans.
Today, almost all platforms offer a function for automatic investment. Depending on the platform, this function is called Portfolio Builder or Autoinvest.
P2P Lending for beginners
If you haven't yet invested in this class, you shouldn't rush into anything, especially in the beginning.
The loan selection is usually very user-friendly and you will find your way around quickly even as a beginner.
Be aware of the risks associated with this investment class.
P2P credits are risky to very risky. For this reason you have to assume that you may lose your invested capital in the worst case.
Therefore we recommend that you invest a maximum of 10% of your capital in this investment class.
This value is calculated because with your other investments you would need a one-time annual return of about 11% to recover a possible total loss.
A total loss represents an absolute disaster and the probability of this happening is low. Nevertheless, we recommend that you invest no more than 10% of your assets in this investment class.
Step-by-step instructions for investing in P2P loans
We have created a short P2P guide to help you get started investing in peer-to-peer loans.
- Before you even consider which platforms you want to invest in, you should decide what percentage of your assets you want to invest. Beginners should not invest more than 5% of their assets. The maximum you should invest is 10% of your total assets.
- You should select at least three platforms from which you want to obtain loans.
- Register and legitimize yourself on the respective platforms. Typically this will take no longer than 3-5 days. For example, if you want to get started on the weekend, it is best to register on Monday or Tuesday.
- Familiarize yourself with the platform in detail. After this you automatically invest in the loans. If you are investing for the first time, invest in loans with short maturities and good creditworthiness.
- During the next 3-6 months you will monitor how your investments develop on the respective platforms.
- If you are not satisfied with the respective platform, cancel the automatic investment, then withdraw your money gradually.
Investing automatically with a Portfolio Builder or Autoinvestor
If you want to invest your capital over several platforms, you will quickly find yourself getting frustrated in the beginning when you want to divide your capital over hundreds of loans.
For example, if you were to invest $ 1,500 across 3 platforms with an investment of $ 10 per loan, you would have to select 150 loans.
Even when the loans become due, you would still have to reinvest the money that was returned through various loans.
That's why almost all major platforms now offer a function that allows you to invest automatically. All you need to do is to specify your general conditions at the beginning and the respective platform will select the loans for you.
Passive income with P2P lending
Because the returns on this investment class are very high, many investors choose to use it as a source of passive income.
With an average return of 12%, you only need to invest $ 100,000 and receive $ 12,000 per year in interest. This corresponds to about $ 1,000 per month before taxes.
Nevertheless, the P2P investment class has a very specific risk, namely that the individual platform may go bankrupt.
When a platform goes bankrupt, your money on that platform is irretrievably lost.
This is why we recommend considering P2P loans as a part of your overall passive income strategy.
Once you are aware of the risks, you can invest more.
Borrowing money with peer-to-peer lending
In recent years, P2P platforms have established themselves as a genuine alternative to bank loans.
Individual platforms offer credit seekers a completely digitized process. In some cases, the loan is paid out to the specified credit account within 24 to 48 hours.
How do I get a P2P loan?
The requirements for obtaining a peer-to-peer loan are similar to obtaining a loan from the bank.
It is important to ensure that you can repay the loan you have taken out. For this you have to be sufficiently creditworthy and need a regular income.
If you meet both of these requirements, you can apply for a loan from a P2P platform.
What role does your credit score play for P2P loans?
Many platforms advertise that credit scores do not play a major role in the granting of loans.
Unlike banks, P2P platforms usually offer you the chance to get a loan even with a poor credit score. But you should expect very high interest rates.
Most of the time, P2P platforms request your credit score. This credit score is a very important feature to assess your creditworthiness on the platform.
You should expect that your credit score will play an important role, contrary to the advertising promises.
Applying for a P2P loan
In the case of a peer-to-peer loan, the loan application process is comparable to that of a classic bank loan.
- You have to register on the P2P platform.
- This is followed by the legitimization by means of your identification documents, usually with VideoIdent (or a similar provider).
- You apply for a loan, providing personal and financial information about yourself.
- Optional: The platform performs a credit check to obtain a better picture of your financial situation.
- Your application will be reviewed by the platform.
- If it is approved, you will either receive your desired credit within 24 to 48 hours or you will have to wait until a sufficient number of users that want to invest in your loan have been found.
On the last point you can expect to get your desired amount paid out very quickly in the case of a consumer loan.
Regulation of peer-to-peer lending
P2P platforms are regulated differently depending on the country.
In the US, platforms have been regulated and monitored by the SEC since 2008.
Within the EU, the individual platforms are monitored by national institutions or supervisory authorities, each country having their own regulations. To standardize these regulations, European Crowdfunding Service Provider Regime was adopted in October 2020.
Peer-to-Peer (P2P) lending taxes
Profits from P2P loans are considered interest income and you must pay taxes on them.
How you are taxed on your profits depends on your place of residence.
In response to numerous requests, many P2P platforms provide their investors with statements that they can then use for their tax returns.