Why P2P Lending Should Be Part Of Every Well-Diversified Portfolio
Peer-to-peer lending is a financial innovation that has seen strong growth since the 2008 financial crisis, when banks started to sharply decrease their lending activities. Peer-to-peer lending, also referred to as P2P lending, is a method through which small businesses and individuals can borrow money directly from private investors, without the use of a conventional financial intermediary.
For example, if a small business wants to borrow $25,000 to finance its expansion, but is unable to get a business loan form a bank with a reasonable interest rate, then that small business could go to a peer-to-peer lender and, if approved as a borrower, can list its loan on the peer-to-peer lending platform for private investors to invest in. Interest rates at peer-to-peer lending platforms can vary from 3% to 30% depending on the borrower’s creditworthiness, but the most reputable peer-to-peer lenders, such as Prosper or LendingClub, generally offer around 6%-10% interest rates on their various peer-to-peer loans.
Peer-to-peer lending is therefore a great financing option for individuals and small business seeking funding. However, it is equally beneficial for those looking to invest their money. In the current low interest rate environment, which causes yields on traditional fixed interest securities such as government and corporate bonds to be rather low, peer-to-peer lending offers a higher yielding alternative for investors. Due to the higher perceived credit risk of peer-to-peer lending investments, yields tend to be higher than for bonds. Hence, as an investor you can generate higher annualized long-term returns investing in peer-to-peer loans than in bonds.
However, that is not the only reason you should allocate a part of your investment portfolio to peer-to-peer loans. The other main reason is because peer-to-peer lending investments are uncorrelated to traditional financial securities, such as stocks and bonds. That means that if the stock market or the bond market suffers a correction, the returns on your peer-to-peer loans should stay unaffected. Therefore, peer-to-peer lending is a great tool for portfolio diversification.
The way peer-to-peer lending works from the investor’s point of view is very straightforward. Firstly, you choose how much of your capital you want to allocate to peer-to-peer lending. Then you sign up to a peer-to-peer lending platform and browse through the listed peer-to-peer loans and choose which ones you would like to invest in, by gauging their riskiness and the interest they pay. Once you have found the right peer-to-peer loans you want to invest in, given your risk profile, you invest a share of your investment capital dedicated to peer-to-peer lending into each loan. It is always best to diversify within your peer-to-peer investments to reduce specific borrower risk. Once you have made your investments, interest payments and repayment of the principal amount at the loan’s maturity date will be paid to you automatically by the peer-to-peer lending platform. That is also why peer-to-peer lending can be considered as passive income, as you only invest once and then money comes in, via interest payments, and you don’t need to do anything else.