All the Buzz About P2P Lending

As anyone who has read Rich Dad, Poor Dad can tell you, the rich spend their discretionary income to buy assets and the poor use theirs to buy liabilities. It's important to remember the simple definition: An asset puts money in your pocket each month, and a liability takes it away. While those concepts are relatively easy to understand, the trouble for many people is finding assets to buy. Few want the headaches of owning rental property, the volatility of the stock market, or the low rates of bonds or savings accounts. What we are all looking for is better than average returns with less than average risk. A new investment tool, called peer to peer (P2P) lending, has recently started gaining popularity. In the classic risk vs. reward battle, this one fares very well.

Imagine that a friend of yours was considering a bank loan for an upcoming purchase. If you had some extra money lying around, then you might be able to help your friend out in a way that actually helped you both. By splitting the difference in interest rates between what your friend can get from the bank and what you can get in a savings account, it becomes a win-win situation. For example, let's assume you have an HSBC Direct banking account which is currently offering 5.05% APY. If the best rate your friend can qualify for at the bank is 15%, then you might compromise on a rate of 10%. You would be getting a much better return than if you had put your money in the bank, and your friend would be paying much less in interest than if they had borrowed from the bank.

While we may all have friends who need money, they won't necessarily need it at the same time, or in the same amounts, that we have it available. If you had thousands, or millions of people looking for money, then it would be easier to find someone to loan to when, and at what terms, you were looking for. To satisfy this need, many P2P lending websites have come about in the last few years. They offer a place to match borrowers and lenders, as well as handle the legal details of the loans, taxes, etc.

Since you most likely won't know the people you are lending to using a P2P lending site, different methods of establishing trust are used. Trust is important, because while you do get a better rate of return in the example above, you also take on more risk, since the return payments are not guaranteed. In the example above, you were willing to take on that extra risk because of the trust that you have with your friend. If you didn't know the person you were lending to, you'd like some extra assurances that they were likely to pay you back. When banks make a loan, they'll largely base your interest rate on your FICO score. This is a single number that basically represents your credit-worthiness, i.e. your likelihood to repay.

The P2P lending sites tend to use this number as a starting point for your interest rate as well. Some sites assign you a credit rating based on your score. Then users will bid on an interest rate for your loan, taking your credit rating into consideration. Other sites pre-qualify you at a certain interest rate based on your credit-worthiness. Users would then be matched with loans that meet their desired criteria: interest rate, cause, or specific loan. You can even loan to specific groups of people, such as Alumni from your University or Retired Teachers, etc.

Regardless of which P2P site you decide to use, its always a good idea to diversity your loan portfolio. Think about how much your risk would be reduced if you loaned $25 to 40 people instead of $1000 to one person. In the first case, if one or two people defaulted before they had completely repaid the loan, you would still make a profit. Obviously, in the second case, you might lose a lot more if the one person you lent to didn't fully repay. As with any investment, I recommend that you start small, see how it works for you, and then expand on that method as its success becomes more apparent.

Here are a few P2P lending sites to take a look at:
Prosper
Lending Club
Zopa