The Truth About Peer to Peer Lending

Peer to peer lending sites connect people who need to borrow cash, with those who have extra to lend. Simplified, you act as the bank and profit the interest. The benefit here is that these companies have lower overheads, which allow them to offer lower interest rates. It sounds great in theory but when I took a deeper look and researched the fundamentals of these companies it raised concerns.

1. Fees

Lending club specifically charges a one percent fee on any payments you receive from the borrower. This means whatever return you were going to get is already decreased by 1 percent.

This seems a little over the top, considering there are companies that offer fee-free index funds that can yield a higher return.

Key point—1 percent can be a lot in the grand scheme of things. A 9 percent return and a 10 percent return can make a difference.

2. Lack of Liquidation

If you invest in a note, you are usually tying your money up for three to five years until the loan matures. That is assuming the borrower pays the loan in time. If you need access to those funds sooner, you’re forced to sell your notes. (Often for a lot less than you paid.)

If you are considering peer to peer lending, be confident that you will not need the money soon and that a better investment won’t arise.

Key point—peer to peer lending is not for the investor who may need their money in the near future.

3. Taxes

Returns from peer to peer lending is taxed as ordinary income, meaning they’re taxed at the highest rate, depending on how much you make, this could be substantial.

Investing in the stock market gets a standard tax rate of 15 percent, while if someone is in the 30 percent tax bracket, 30 percent of their peer to peer lending is going to taxes.

In addition to this, the S&P 500 on average yields a 12.3 percent return, while peer to peer lending sits at 7 percent.

4. Risk

Many peer to peer lending companies assume little to no risk in assessing borrower's credit. This raised a red flag and seemed like an easy feature for people to take advantage of.

If the borrower cannot get a loan from a bank or other traditional borrowing companies. They are most likely going to resort to peer to peer lending, meaning you’re assuming the risk the bank would not.

This is a major concern considering banks have the funds and scalability to issue loans at pretty low rates.

Another major issue with peer to peer lending risk is in their fine print, it says that they do not require income verification and will sometimes go off stated income. What is preventing someone from falsifying their income, getting a loan, and completely disappearing? Some people who do not care about their credit score will take advantage of this for two or three loans and go off the grid.

Peer to peer lending will not pursue them legally because it is a lot easier to write it off on taxes as a loss. Which means your loan gets sold off to a debt collector for pennies on the dollar and the chances of you getting your money back diminishes.

Keypoint—the risk seems to outweigh any optimism for a large return.

5. High Learning Curve

Most Americans don't manage their own financial portfolios. Instead, they rely on investing through third-parties like an employer’s 401k.

Peer to peer lending still remains pretty complicated for the average investor. The main confusion stems from choosing loan grades and diversifying in over 200 notes.

A new investor needs time and patience to understand what "grades" are, self-assessing their own tolerance of risk and other components that go into diversifying a portfolio.

This problem is most apparent looking at Lending Club and Prosper’s websites. Both require people to manually select their own loan grades while also needing them to manually diversify across enough notes. This type of responsibility is too overwhelming for the average individual.

Key point—peer to Peer lending is not suited for the new investor.

Wrapping It Up

Peer to peer lending is too new to know how to adapts to market fluctuation, it’s taxed like regular income, and the risks outweigh the gains. These are key things to consider when deciding on an investment. There are benefits to using the service but consider it very carefully before making anything official because you are committing to it for three to five years at the least.