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Woman holding the money she made from investing in peer to peer lending

Peer-to-Peer Lending: The Good, the Bad, and the Ugly

Peer-to-peer lending (P2PL) in is exactly what it sounds like — a loan between two parties, without all the trouble of a bank loan, making it faster and more efficient. Typically, peer-to-peer loans are established using a website that acts as an intermediary. If you break down all the fancy legal jargon in the contract between the intermediary site and the lender, as well as between the intermediary site and the borrower, the idea is clear enough; the question is, it a good idea? 

For the Lender...

Everything is fairly straightforward and peer-to-peer lending can be a very good investment. Most P2PL websites have a minimum and maximum amount lenders can invest. Minimums are usually somewhere in the vicinity of $25 per loan for a $2,000 total and a max of $1,000,000, respectively. Less than $25 is basically a waste of everyone’s time, and more than a million has to be taken into consideration by the intermediary, because their intent is to keep it fair — a lot of the loans are fairly small, and they want to make sure there’s enough to go around. 

The process is pretty simple. You create an account, hook up your bank account, and start picking out loans that you want to fund. Most of the websites provide borrower profiles, so you can see how trustworthy they appear. Each loan is generally ranked on how safe it is to invest, which is based on the borrower’s credit score, loan history, and more. Most of the loans are on a three or five year return rate, and for the most part you’re looking at about an 8% interest rate return. If you have the money to play with and the metaphorical cojones, higher risk loans usually offer a higher return rate, and might be worth your while. 

But things can get very tricky, very technical, and very vague. To decide if P2PL is a good investment for you, you need to understand how the lending process works for both parties. As a lender, you stand to make a lot of money, but you're also in an insecure position because the contract doesn’t guarantee much. You aren’t buying stocks or just handing over cash, you’re buying “notes” from the company for the borrower.

Once you choose someone to loan your money to, that money is essentially frozen until the borrower is funded to the required percent of their asking price. At that point, you officially buy the loans and enter into the agreement with both the platform and the borrower. Once you start getting payments, you can cash out or reinvest into more loans to make more money off your profit. The intermediary company takes no responsibility for taxes you need to pay, losses you may get hit with, or much of anything else. The one thing the contracts are clear about is that you may very well lose your investment, and you should be prepared for that. You can’t give away your investment without their consent, but they can. 

If a borrower defaults or some other calamity happens, they guarantee you’ll get the money back that you put in, but they don’t promise any interest. If the borrower goes to collections, you can expect to lose around a third of your investment to legal fees and what have you. If it turns out you loaned money to an identity thief, most places promise to “credit your account,” but whether that’s cash into your bank account or platform credit is not clear. The scariest part is probably the fact that these loans are generally unsecured, meaning the only collateral is good faith.

For the Borrower...

Peer-to-peer lending terms aren't so great. Most P2PL platforms reserve most of the rights to the loan. There’s an origination fee, which usually comes out of the loan, which means the borrower doesn’t get the full amount of the loan (and they have to pay interest on the origination fee). Quite frankly, P2PL isn’t a very good idea for any kind of large, long-term loan (like a business loan, for example). Because here’s the deal — once you’re in, you’re in. There is no excuse not to pay the loan, and they will get try to get the lender's money back by any means necessary, including chasing you through collections. Once they default, the borrower owes everything immediately. 

Since there’s no collateral, if you simply don't have the money, how does the lender get it? They can pass you off to a collections agency, bring in attorneys, and if that doesn’t work, they start finding people connected to you who can pay through their arbitration clause. Not only that, they can sell loans without asking or informing you — which may mean a new interest rate or new loan terms.

Although these stipulations may not seem like much, they can really come back to bite you. For example, if you apply for a $20,000 loan and enough lenders buy notes that you actually get it, then you die 28 days later, your loan is in default and you owe everything. Immediately. Your wife, who is a third party, can’t just take over your loan. Instead, she's responsible for paying the whole amount, including any fees, attorney fees, or collector’s fees and the full-term interest. The only options are to pay the loan immediately or apply for an opt-out letter. In the meantime, you’ve given them permission to turn the loan over to collections, or contact anyone in anyway connected to you. 

In Conclusion...

If you’re an investor looking for something easy and low-risk, peer-to-peer lending is probably a good investment for you. For a borrower, if an 8% interest rate with aggressive terms is your best option, then it's your best option. Remember that these loans don’t go away, for borrower or lender, in any way, shape, or form so it's more important than ever to make sure that you read every line of the lending contract.

Last Updated: September 17, 2015