The Beginner’s Guide to Peer-to-Peer Lending

The Beginner’s Guide to Peer-to-Peer Lending #personalfinance #p2plending #moneytipsDearly beloved readers, we’re gathered here today to witness the union of a special “bond” between a borrower and an investor.

Investor, do you wish to lend your hard-earned dollars to this borrower, given their financial history and the potential risks involved?

“Yes.”

Borrower, do you take this investor’s money and promise to honor the loan agreement and operate in good faith?

“Yes.”

By the authority vested in me, you may now proceed with this financial transaction.

If you have read my recent net worth updates, you know I can’t stop hyping up peer-to-peer lending (also known as P2P lending). I even got my very-risk-averse husband to grow an interest in it. He opened his account last month, and already put in $1,000.

If you’re unsure what P2P lending is all about, don’t worry, you’ll have a much better idea after reading this article. I promise.

What is P2P Lending?

In a nutshell, P2P lending is a method for businesses to get the funding they need directly from investors like you and I in exchange for monthly interest payments on top of ongoing principal repayment.

This way, businesses could get a loan quickly – whether it’s for capital expenditure, loan consolidation, inventory or marketing – without the hassle of dealing with traditional lending institutions.

Once a business’ loan application is approved by the lending platform, a funding request is then listed on the loan marketplace for potential lenders to invest in. If enough investors are interested in a loan such that it gets fully funded within 30 days, the deal gets finalized and repayment begins the following month.

Advantages of Investing in P2P Lending

As an investment vehicle, P2P lending is accessible to almost everyone regardless of net worth or income. It is also easy to understand, and even easier to get started. I kid you not, you only need to deploy $200 to access the loan marketplace and start lending.

Worried about the lack of transparency? Not a problem. You have access to all the business and financial details you need in order to make informed investment decisions. Besides that, you have total control over which loan you invest in.

One of the biggest advantages of P2P lending is its attractive returns. Depending on the size of your initial investment and your risk tolerance, P2P lending could definitely become a decent source of passive income for you.

Now that I’ve talked extensively about how awesome P2P lending is, let’s talk about the drawbacks:

Disadvantages of Investing in P2P Lending

  1. It’s risky.

Depending on a business’ credit score, financial metrics, and the dollar amount that they’re seeking, each loan is assigned a credit rating ranging from A+ to E, with A+ loans being the safest.

Naturally, with great risk comes great reward. Here’s a look at the credit ratings and their corresponding interest rates (i.e. your annual returns) at Lending Loop (Canada’s most established P2P lending platform):The underlying assumption is that, loans with “E” ratings have a much higher default rate than loans with “A+” ratings. But even with “A+” loans, there is no guarantee that you will recoup all of your investment.

As much we try to invest in profitable, sustainable and trustworthy companies, sometimes stuff happens that are beyond any single person’s control – perhaps the local economy took a downturn, a new competitor took a big chunk of the market share, or a major client ran into cash flow issues themselves and failed to pay on time.

At the end of the day, a business can do everything right but still defaults on their loans. It’s a sad but unavoidable facet of investing that we always have to keep in mind.

  1. Your funds will be tied up for years.

In terms of liquidity, P2P lending gets a 3 out of 10 in my book.

Once a loan that you’ve invested in is finalized, you won’t get every cent of your principal back until the end of the loan term, which is usually between 2 to 4 years. That is a fairly long time to go without the option to withdraw all of your initial investment (even at a loss).

With that said, it’s far easier to stomach this level of illiquidity if P2P lending only constitutes a small portion (less than 10%) of your investment portfolio.

  1. 100% of your interest income is taxable.

Unlike stocks, bonds, mutual funds, ETFs, and GICs (not meant to be an exhaustive list) that could be held within your TFSA and RRSP and allow you to enjoy tax-free earnings, P2P investments cannot be held within your tax-sheltered accounts. Therefore, all of your P2P interest earnings will be taxed at your marginal tax rate.

Depending on your taxable income and the province in which you reside, a significant portion of your P2P profits might be effectively wiped out by taxes, making it a less desirable investment than, say, select index funds that average 6% return or more that you can hold within your RRSP and TFSA.

One Platform, Two Strategies

My husband and I have invested $1,000 and $500 in P2P lending, respectively, but our strategies are drastically different.

Here’s how my husband approaches it (credit to my husband for his help in writing this part):

As a conservative investor who only held GICs in his RRSP for the longest time, he welcomed P2P lending with open arms (to my astonishment).

He very much embraced the idea of helping small Canadian businesses while making a buck in the process. And who can blame him!

Shortly after signing up, my husband noticed an odd (lack of) pattern: loan listings would sometimes arrive in droves, and then nothing new would pop up for days.

It’s hard to predict when new loans become available on the marketplace, so he decided to take advantage of Lending Loop’s Auto-Lend feature. As the name implies, Auto-Lend lets people automate the lending process based on pre-defined criteria.

My husband has set up his custom Auto-Lend plan to automatically contribute $50 to each loan that is in the A, B and C risk bands, as soon as they’re available. This way, he is happy with his ROI (return on investment), and sufficiently diversified without exposure to too many risky loans.

Contrary to my husband’s passive approach, I used to evaluate every single loan request as if my life depended on it.

My assessment process was fairly thorough and tough (perhaps unnecessarily so).

First of all, I looked for loan requests that match my risk tolerance and liquidity requirement.

  • Risk: Like my husband, I only invest in loans that are in A, B and C risk bands, for reasons stated above.
  • Loan Term: I strongly prefer loans that mature within 3 years, though I have invested in 4-year loans in the past.

Then I looked for signs that the business in question has a great track record, opportunities to grow, and a proactive leader at the helm.

I’m not necessarily looking for boldness, innovative thinking, creativity, and charisma – traits that are traditionally associated with a successful startup founder. As far as I can see, the majority of businesses that chose to raise funds through Lending Loop are lifestyle businesses, in which case, attitude, integrity, attention to detail, and the ability to make rational decisions matter a great deal more to me.

Specifically, I asked myself these questions when evaluating a business:

  • Website: Is the website search engine friendly, well designed, and easy to navigate? Does it fulfill its purpose of converting site visitors into sales or leads?
  • Loan Details: Does the business explain their business model and core strengths in a professional and logical manner? Is their reason for loan request reasonable? Do they provide a compelling argument to reassure lenders that they’re safe to lend to?
  • Financials: Has the business revenue been increasing year over year? Are there financial discrepancies that need to be addressed in the Q&A?
  • Q&A: Does the borrower promptly answer questions asked by potential lenders? Do they demonstrate business acumen? Do they provide satisfactory answers to tough questions?

Researching each company might seem like a lot of work. But believe it or not, I genuinely enjoyed it and didn’t mind doing the “work”. My hopes were that, by carefully weighing the pros and cons of investing in each loan, I would have a better chance of avoiding charge-offs and receive a higher return on my overall investment.

But my well-crafted plan sort of backfired.

Precisely because I took the time to evaluate each loan, I missed out on numerous loan requests that were funded within hours of being available (before the alert email even reached me).

So out of necessity, I have turned on Auto-Lend myself so I would never miss an opportunity again.

As of right now, my outstanding principal balance is at $495.35, earning an average of 12.7% before taxes and fees. For now, I’m happy with it, and plan to put even more money into P2P lending and reinvest the accrued interests.

I will definitely keep you guys updated on our progress and share any additional tips we have.

Have a question about P2P lending that I didn’t address? Ask me in the comments below!

Category: InvestingPassive Income

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Article by: Miranda Flys

Miranda is a personal finance blogger, pizza connoisseur, and lover of Lego products. You can catch her rambling about money on Facebook and Twitter.