Making Money Banklessly: Is Investing in P2P Loans a Good Idea?

Alternative investments are giving traditional finance a run for their money these days, but the one sector banks have historically dominated is interest-bearing loans. Interest rates have existed for as long as money has, but banks have monopolized the industry, effectively making them the gatekeeper for anyone who needs to borrow money. One way to break this mold while earning passive income is by investing in peer-to-peer loans.

Now, you may be thinking: P2P lenders sound an awful lot like "loan sharks." Loan sharks are unlicensed moneylenders known for being predatory, but investing in P2P loans is actually legal as long as you follow local regulations. However, P2P loans are not money printing machines—there are inherent risks to lending your hard-earned dollars out to strangers. Here are the pros, cons, and what you need to know to decide whether investing in P2P loans is right for you.

Traditionally, lending is practiced by banks and other financial institutions in a highly regulated environment. In the past, if someone needed a loan, they had no choice but to meet the bureaucracy's parameters—and those parameters often disqualified many potential borrowers. Peer-to-peer loans are different because they simulate this system without a bank, replacing it instead with peer-to-peer lending platforms that match borrowers directly with individual 'lenders,' or investors.

The reverse auction model allows potential lenders (investors) to charge any interest rate they want. This is great because it gives you, the investor, a higher degree of agency when it comes to the terms of the loans you're providing. While you get to choose how much interest you want to charge a given borrower, borrowers are able to shop among all potential lenders for loan offers with the most favorable terms. 

It's called a reverse auction because the lender offering the lowest interest rate usually wins. In other words, you can set a higher interest rate in hopes of earning higher returns, but your chances of securing a borrower willing to accept that rate (especially one who's likely to repay on time) will be lower. So, by setting your rate higher you invite riskier borrowers to take up your offer.

Choosing the right peer-to-peer loan platform is crucial because they're responsible for enforcing the terms of the loan. If someone invests in a P2P loan platform that, say, shuts down for some reason, then there is no longer a central authority keeping track of the loans, which could result in lenders losing their entire investment. While this is an unlikely scenario, it has happened before, so it isn't impossible, either.

Platforms also vary in the structure and size of loans they offer, so it's recommended not to put all your eggs in one basket. Investors should manage their risk by spreading their investment over several borrowers rather than just one because investing in a bunch of small loans to different people is safer than investing in one big loan to one borrower. You can also hedge against the risk of one platform going bust by investing in multiple competing platforms. 

Another drawback of P2P lending platforms is that they can't insure deposits the same way banks do. This means that, if the borrower defaults on their loan, lenders have little to no recourse for recovering their funds. Properly assessing a borrower's creditworthiness is crucial when investing in peer-to-peer loans.

The heightened risk is exacerbated by the fact that P2P lending platforms can attract borrowers who are ineligible for a loan from a bank. Since these borrowers often have low credit scores, lenders must do their due diligence to scrutinize the borrower's track record before offering them a loan. For lenders, this means that risk tolerance is the main factor to consider when making offers to potential borrowers. This also means that borrowers with poorer credit are more inclined to accept a higher interest rate, making them more profitable for the lender.

With the proper safeguards, P2P lending is a lucrative investment. Investors in P2P loans can make returns that outperform consumer products like certificates of deposit (CDs) and high-yield savings accounts. So yes, you can make money from P2P lending, but this isn't a way to earn cash fast and get rich quick. The benefits of P2P loans are balanced by their disadvantages.

While returns on P2P lending are generally higher than other investments, annual returns vary across different platforms and borrowers depending on the system used to determine interest rates. Generally speaking, P2P loans start at 4% interest and go up depending on the borrower's creditworthiness, how soon they pay back the loan, and how interest is compounded, if at all.

It isn't uncommon for P2P lenders to earn on average upwards of 5% or even 6% on top platforms like Worthy and Prosper, given a borrower that is willing to accept those terms and will abide by them. One thing investors should watch out for are fees since platforms have the discretion to charge however much they want. While not all use this revenue model, Prosper, Yieldstreet, and other platforms charge a loan servicing fee of 1%, and that fee can eat into investor returns. It's important to do your own research when choosing a platform since fees are always subject to change.

While high returns are great and all, the above paints an all-too-rosy picture of P2P lending that doesn't exactly line up with the more nuanced reality. It's hard to juxtapose the costs of investing in peer-to-peer loans versus the benefits because there are numerous other factors to consider. Below you'll find a summary of the good and bad that comes with investing in P2P loans.

On average, investing in P2P loans is more profitable than most traditional investments, like buying into an S&P 500 index fund. Although it takes a little more work to begin P2P lending compared to opening a certificate of deposit, there is little to compare when it comes to which one will generate more yield. Both are investments that involve tying up your money for a foreseeable future, so picking the one that will make you richer is a no-brainer.

Another big advantage is that instead of working with a bank, you become the bank. As an investor, you become responsible for vetting borrowers, determining interest rates, and collecting interest. P2P lending empowers investors to loan money on their terms, which means you have the agency to choose how much money you want to earn and what you'll risk to earn it.

One main drawback of investing in P2P lending is that you'll always be beholden to your platform of choice. While most of the bank's duties are transferred to the investor, platforms are the only central authority to enforce the terms of the loan. This means that platforms can cease their services at any time, which is certainly a liability. As an investor, it's important to conduct rigorous research and choose a reliable platform that won't disappear with your money.

If you're investing in a lending platform that suddenly vanishes, well, you're shit out of luck. P2P loans are uninsured and largely unregulated, so the lack of such safeguards poses an additional layer of risk. A platform going under is the worst-case scenario, but this also means borrowers can more easily get away with delinquency.

This brings us to our final point: One of the duties you take on as a P2P lender is conducting credit checks on potential borrowers. While checking someone's creditworthiness is not particularly hard, it is time-consuming and requires more work than just opening a savings account or CD. So, if you're looking for a hands-off investment, this isn't it, chief.

So, what have you got to lose? More importantly, would you be okay with losing it? These are risk assessment questions you must ask yourself before investing in P2P loans. This can be a high-stakes venture, and as the uncle of a local neighborhood superhero once said, with great power comes great responsibility.

Some platforms offer investors more agency in determining who their money is loaned to and how much interest to charge them. But, this also means the onus is on you to conduct a background check on these potential borrowers. This can be a lengthy and involved process that shouldn't be overlooked, so if you don't have a penchant for investigating a person's financial history, you should probably look for platforms that conduct thorough due diligence for you. Alternatively, investors looking for a more passive and traditional way to invest in loans can invest in peer-to-peer lending platforms through the stock market, such as Lending Club Corp. (LC), or bank loan mutual funds, like the Fidelity Floating Rate High Income (FFRHX).

 For those willing to put in the time and effort into researching their investment opportunities, P2P loans are a great way to make your money make money. If you're still unsure, you can always view this investment through the classic lens of the risk-reward ratio. If you're comfortable with taking a higher risk for the potential of higher returns in the future, then P2P loans might be a good idea for you.