Investing is key to building wealth, and a common refrain for anyone who offers financial advice is that you need to make sure your investments are diversified. That can mean not putting all of your money into a single stock. It can also mean investing in a wide variety of assets. Peer-to-peer lending is a relatively new way to invest that offers some diversification when compared to traditional investments like stocks and bonds, but is it right for you?

What Is Peer-to-Peer Lending?

Peer-to-peer lending involves individuals offering loans to other individuals in return for regular interest payments. Rather than borrowing money from a bank or other business, borrowers receive money directly from other people.

At its most basic level, lending your friend $20 to buy lunch is a form of peer-to-peer lending, but in the world of investing, it typically refers to larger loans that are funded by individuals but managed by companies that are in the business of facilitating peer-to-peer loans.

The typical process looks like this:

  • A borrower applies for a loan.
  • The peer-to-peer lending business assesses their creditworthiness and offers the loan terms.
  • If the borrower accepts, the peer-to-peer lending business posts the loan on its website for investors to fund.
  • Individual investors can view loans that need funding and see details like the amount needed, credit rating of the borrower, and the interest they’ll earn.
  • Investors can fund a portion of the loan, usually with a minimum amount required.
  • As the borrower makes payments, the peer-to-peer company distributes the principal and interest to investors. If the borrower defaults, investors can lose money.

A few different companies specialize in peer-to-peer lending, such as Prosper and Lendermarket.

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Should You Invest in Peer-to-Peer Lending?

Peer-to-peer lending offers a unique opportunity for people who want to add a new asset class to their portfolios. Some reasons to consider investing in peer-to-peer loans include:

  • Higher potential returns: Peer-to-peer loans usually offer higher potential returns than bonds and other investments that offer a regular stream of income. For example, Prosper reports an average return of 5.2% while Lendermarket reports an average interest rate of 13.46%.
  • Shorter investment duration: Most peer-to-peer loans have payment timelines of a few years, usually no more than five. That is much shorter than many longer-term bonds, which can have repayment periods as long as 30 years.
  • Diversification: Peer-to-peer loans let you add a new type of asset to your portfolio. Most websites also make it easy to spread your funds among many different loans so you can diversify your portfolio of peer-to-peer loans.
  • ESG investing: Some platforms, like Kiva, are less focused on financial returns. Instead, they help investors offer loans to underserved or marginalized communities around the world.

Dangers of Peer-to-Peer Lending

Peer-to-peer lending isn’t perfect, and it can involve plenty of risk. Here are some reasons to avoid investing in peer-to-peer loans.

  • Single-party risk: Many large peer-to-peer lending sites have closed or gone under. If you invest through a single site that shutters, you could lose your entire investment.
  • Taxes: Peer-to-peer loans are highly tax inefficient. It’s typically treated as interest income and taxed at your standard income tax rate, which for physicians is usually quite high.
  • Falling returns: Many people who have invested in peer-to-peer loans have found that returns fall significantly over time. Dr. Jim Dahle, founder of The White Coat Investor, saw initial returns over 12% that later fell to just over 7% within a few years of investing in peer-to-peer loans.
  • Portfolio complexity: Opening a new financial account always adds complexity to your financial life. That complexity may not be worth the potential benefits of a new asset class.
  • High effort: To invest in peer-to-peer loans, you need to select each individual loan you want to fund. Their short durations also mean you need to regularly make decisions about where to reinvest your money once a loan matures.
  • Potential correlation with the overall economy: Peer-to-peer loans are unsecured, meaning there’s not much protecting you if the borrower defaults. If the economy goes bad and people start struggling to pay bills, you could see large losses in your peer-to-peer loan portfolio. Other securities, like stocks, may also lose value, but you could try to hold them through the downturn until they appreciate. With peer-to-peer loans, default is usually the end of the line for investors.
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Strategies for Success

If you think that investing in peer-to-peer loans is the right move for you, keep these tips in mind.

  • Diversification is key. Try to spread your investment across many different loans rather than putting all you have in one investment. If one borrower defaults, you’ll lose less than if you’d focused on just a few loans.
  • Select loans in multiple credit brackets. Higher-risk loans offer higher potential returns, but the odds of default are greater. Consider investing in higher-quality borrowers to reduce risk.
  • Consider using multiple platforms. Just as you should diversify your money into multiple loans, consider signing up for a few different peer-to-peer loan websites. That gives you access to more loans to invest in and limits your risk if one site goes under.

The Bottom Line

In the end, peer-to-peer loans are a risky asset that offer diversification and potentially high returns. However, for many people, the additional complexity they add to an investment portfolio, the effort to find loans to invest in, and the risk make them not worth the hassle.

If investing in peer-to-peer loans doesn’t seem like the right move for you, consider investing in bonds. Some bonds can offer a few of the benefits of peer-to-peer loans, like higher potential returns, with less complexity and risk.

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