In recent years, the popularity of peer-to-peer lending, or P2P has skyrocketed. The debt crowdfunding movement links private lenders with private borrowers, cutting out the middleman of a bank or credit union. P2P platforms are swelling with private investors, and the funds in their bank accounts — but is lending your savings worth it?
What is P2P lending?
Traditional lending takes place between a depositor, a financial intermediary, and a borrower. At a high level, a depositor puts their money into a savings account, which the intermediary uses to extend credit to borrowers. The concept of peer-to-peer lending seeks to simply connect lenders and borrowers, without giving the financial intermediary a piece of the pie.
The concept has been around for a very long time, but at a much smaller scale. Consider a loan from a parent to a child, which is money lent directly between a borrower and a lender. The rise of crowdsourcing, with the ability to quickly and easily raise large sums of money, gave rise to the current P2P format.
Through a P2P platform, an investor might deposit funds and then select which borrower or borrowers they want to lend to. As the borrower repays their loan, the lender receives monthly payments, consisting of principal and interest. Interest rates are often set at the beginning of the loan, and amortized similarly to a mortgage.
Drawbacks of P2P lending
For some investors, P2P lending is a way to earn interest and receive passive income. By choosing which borrowers to lend to, investors know exactly how much interest they can expect to receive over the life of the loan. However, like with all savings vehicles, it is important to consider the risks, costs, and returns before investing.
The most obvious risk when lending money directly to borrowers is the risk that they can’t or won’t pay you back. P2P platforms usually let you choose the risk profile of your borrower, filtering by credit score, but default still happens. One study found that P2P platforms in certain regions experienced default on upward of 10% of all loans.
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Another major risk is the ability of a P2P platform to stay above water. The P2P marketplace is an incredibly competitive space, and low margins can drive platforms out of business. One extreme example is the 87% of P2P processors that went out of business in China in the late 2010s. Bank deposits offer FDIC insurance, but many P2P platforms offer no such guarantee.
Alternatives to P2P lending
Using excess savings for P2P lending may be a good option for certain investors, but alternative options should always be considered. After all, P2P lending is not the only way for consumers to earn moderate returns and consistent cash flows with their savings.
Safer vehicles for short-term or emergency funds include CDs and money market accounts, the returns of which are currently elevated in our high-interest rate environment. And while those yields will fall with the lowering of the Fed benchmark rate, so too are personal and business loans sensitive to such economic changes. For long-term savings, however, savers should consider investing in a well-diversified, risk-appropriate portfolio of stocks and/or bonds.
The rise of P2P platforms has allowed lenders and borrowers alike to cut out the middle man of financial intermediaries through direct loans. However, while lenders can vet borrowers, they should also consider the implicit risks associated with extending unsecured loans on platforms that do not offer FDIC insurance.
P2P lending may be suitable for some savers, but the risks and returns of such investments should be compared to alternatives.