By working with borrowers directly, an investor could make more money because they, rather than a financial institution, decide what interest rate to offer a borrower.
Several years ago, my husband and I walked into a local auto dealership to purchase a “newer” used car. Before our journey to the dealer, we had made sure to be preapproved for an auto loan by our bank. When it came time to complete the financing paperwork, the finance manager told us that the ‘preapproval’ from our bank was going to result in an interest rate of 6.5.% for a 60-month loan, even though our credit scores were both in the 750 range. He then mentioned a local credit union that he felt could likely provide us with the same loan for a lower interest rate. Sure enough, after we completed and submitted our loan application to the credit union, we were offered the same 60-month loan for a 2.1% interest rate. This is what the two loans in comparison looked like:
Loan 1
$19,000 auto loan
60-month term
6.5 % APR
$371.76 monthly payment
Total Interest: $3,305.38
Loan 2
$19,000 auto loan
60-month term
2.1 % APR
$333.86 monthly payment
Total Interest: $1,031.57
While the monthly payments for the two loans were only slightly different, the lower interest rate loan was going to save us $2,273.81 in interest payments over the life of the loan! We had presented the same work history, income, and credit profiles to both our bank and the local credit union, yet the credit union had the better offer.
What is Peer-to-Peer Lending?
The idea of creditworthy borrowers being able to shop around for the best interest rate for a loan has created a new form of lending called Peer-To-Peer Lending (P2P Lending).
Peer-To-Peer Lending offers the ability to match borrowers directly with investors who have money to lend tied to a specific interest rate.
This is different than the traditional lending model where borrowers apply to a financial institution without knowing the exact interest rate they will qualify for. Then, once their loan is funded, it is often bundled up with other consumer loans and sold to investors on the back end.
In the Peer-To-Peer lending model, the borrower must first be pre-qualified through a specific platform. Then the borrower can compare interest rates directly from individual investors without going through a financial institution. The borrower only formally applies for the loan after selecting the investor(s) with the best offer.
IMPORTANT: Because these loans are funded by individual investors at their discretion, it may take longer for a borrower to get their loan fully funded then it would through a financial institution.
So why would investors want to work with borrowers directly? By working with borrowers directly, an investor could make more money because they (the investor(s)), rather than a financial institution, decide what interest rate to offer a borrower. The ability to set the interest rates offers the investor the potential for higher returns than they might receive through a Certificate of Deposit or Money Market account. The investor can choose to invest in one loan or a piece of several loans.
Then there is the social factor where the investor gets to know something about the borrower and their reason for needing the loan. This adds a personal element to investing that isn’t found using traditional investing platforms.
The risks of becoming a peer to peer lender
Of course, investing has its risks. For the investor, there is no guarantee that the advertised interest rate is going to correspond with the earnings they actually receive. This partially because the investors are taking on the lending risks directly. In P2P Lending, the lending platform does the initial screening of the borrower but that doesn’t guarantee a borrower won’t default on their loan repayment and lender’s funds are not insured.
Loan Investment risk levels depend on the credit rating of the borrower. The borrowers with the lower credit rating are charged higher interest rates, which in theory could mean more money earned by the investor. However, the same borrowers, because of their lower credit rating, present high risk to the investor. This is why it is important for investors to know their risk tolerance before investing money and become a peer to peer lender.
What companies offer P2P lending?
There are several P2P companies in the market including Prosper, Lending Club, and Peerform. All of these companies make their money by charging fees to both the borrower and the investor. Although some companies may hint otherwise in their advertising, generally only borrowers with good to excellent credit are eligible to take advantage of P2P Lending. If you want to become a peer to peer lender, these platforms are a good place to start.
If you are a borrower, check your credit score before you apply for a loan through a P2P platform. Several banks, credit unions, and companies like Mint, Credit Karma and Credit Sesame will let you see your credit score for free.
3
What is your risk tolerance?
If you are interested in investing through a P2P platform, decide on your risk tolerance first. Then, use a compound interest calculator to determine what interest rate you will offer to get the specific return you are looking for.
4
Know your numbers
As an investor, make sure you can make your investing decisions based on the amount you can afford to invest and your risk tolerance no matter how compelling the borrower’s story is.
About the Author
Dawn Torres-Gale, AFC
Accredited Financial Counselor
In 2008, Ms. Torres-Gale was chosen by the Financial Industry Regulatory Authority (FINRA) Foundation to be part of a select group of military spouses. Through this, she received FINRA sponsored training from the Association of Financial Counseling, Planning and Education and became an Accredited Financial Counselor® in February 2012. Full Bio | All Articles | LinkedIn
Shorter Version
Est. Reading Time: 2 Minutes
Several years ago, my husband and I walked into a local auto dealership to purchase a “newer” used car. Before our journey to the dealer, we had made sure to be preapproved for an auto loan by our bank. When it came time to complete the financing paperwork, the finance manager told us that the ‘preapproval’ from our bank was going to result in an interest rate of 6.5.% for a 60-month loan, even though our credit scores were both in the 750 range. He then mentioned a local credit union that he felt could likely provide us with the same loan for a lower interest rate. Sure enough, after we completed and submitted our loan application to the credit union, we were offered the same 60-month loan for a 2.1% interest rate. This is what the two loans in comparison looked like:
While the monthly payments for the two loans were only slightly different, the lower interest rate loan was going to save us $2,273.81 in interest payments over the life of the loan! We had presented the same work history, income, and credit profiles to both our bank and the local credit union, yet the credit union had the better offer.
What is Peer-to-Peer Lending?
The idea of creditworthy borrowers being able to shop around for the best interest rate for a loan has created a new form of lending called Peer-To-Peer Lending (P2P Lending).
This is different than the traditional lending model where borrowers apply to a financial institution without knowing the exact interest rate they will qualify for. Then, once their loan is funded, it is often bundled up with other consumer loans and sold to investors on the back end.
In the Peer-To-Peer lending model, the borrower must first be pre-qualified through a specific platform. Then the borrower can compare interest rates directly from individual investors without going through a financial institution. The borrower only formally applies for the loan after selecting the investor(s) with the best offer.
IMPORTANT: Because these loans are funded by individual investors at their discretion, it may take longer for a borrower to get their loan fully funded then it would through a financial institution.
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Longer Version
Est. Reading Time: 2 Minutes
What is the advantage?
So why would investors want to work with borrowers directly? By working with borrowers directly, an investor could make more money because they (the investor(s)), rather than a financial institution, decide what interest rate to offer a borrower. The ability to set the interest rates offers the investor the potential for higher returns than they might receive through a Certificate of Deposit or Money Market account. The investor can choose to invest in one loan or a piece of several loans.
*Attributed to Lending Club – www.lendingclub.com/investing/peer-to-peer
Then there is the social factor where the investor gets to know something about the borrower and their reason for needing the loan. This adds a personal element to investing that isn’t found using traditional investing platforms.
The risks of becoming a peer to peer lender
Of course, investing has its risks. For the investor, there is no guarantee that the advertised interest rate is going to correspond with the earnings they actually receive. This partially because the investors are taking on the lending risks directly. In P2P Lending, the lending platform does the initial screening of the borrower but that doesn’t guarantee a borrower won’t default on their loan repayment and lender’s funds are not insured.
Loan Investment risk levels depend on the credit rating of the borrower. The borrowers with the lower credit rating are charged higher interest rates, which in theory could mean more money earned by the investor. However, the same borrowers, because of their lower credit rating, present high risk to the investor. This is why it is important for investors to know their risk tolerance before investing money and become a peer to peer lender.
What companies offer P2P lending?
There are several P2P companies in the market including Prosper, Lending Club, and Peerform. All of these companies make their money by charging fees to both the borrower and the investor. Although some companies may hint otherwise in their advertising, generally only borrowers with good to excellent credit are eligible to take advantage of P2P Lending. If you want to become a peer to peer lender, these platforms are a good place to start.
Actionable Steps
Do your research
Research the loan amounts offered, and interest rate range for each P2P platform. Also carefully check out the fees each platform charges.
Check your credit score
If you are a borrower, check your credit score before you apply for a loan through a P2P platform. Several banks, credit unions, and companies like Mint, Credit Karma and Credit Sesame will let you see your credit score for free.
What is your risk tolerance?
If you are interested in investing through a P2P platform, decide on your risk tolerance first. Then, use a compound interest calculator to determine what interest rate you will offer to get the specific return you are looking for.
Know your numbers
As an investor, make sure you can make your investing decisions based on the amount you can afford to invest and your risk tolerance no matter how compelling the borrower’s story is.
About the Author
Dawn Torres-Gale, AFC
Accredited Financial Counselor
In 2008, Ms. Torres-Gale was chosen by the Financial Industry Regulatory Authority (FINRA) Foundation to be part of a select group of military spouses. Through this, she received FINRA sponsored training from the Association of Financial Counseling, Planning and Education and became an Accredited Financial Counselor® in February 2012.
Full Bio | All Articles | LinkedIn