One of the bigger themes that I like to talk about is the opportunity that the Internet has afforded to the average person. Part of this opportunity is a growing realm of online platforms for investing. With that in mind I would like to talk about peer-to-peer lending or how to become your own bank.
What is “peer-to-peer lending”?
Simply put, peer-to-peer lending is where you become the middle man and lend money to people instead of a bank. In traditional lending the bank is the middle man for lending out money and it works like this:
You deposit money into your savings account with your bank. That bank now takes your money and lends it out to people and buisnessess, sets them up with an interest rate and payment plan, and makes money off of that interest. In return you receive a tiny fraction of the income which is the interest rate on your savings account.
The important part of this transaction is who makes the money off of the interest. Loans can range anywhere from 3% to over 20% in interest payments. In the traditional model, the bank takes almost all of the interest and you are left making less than 1% (currently) of that interest. The bank does assume the risk that someone will not pay the loan back, which I will cover below so you will never lose your deposited money but you won’t make much off it either. In total, the bank takes the risk, makes the money, and you are left with the smallest portion possible.
So you are in the bank:
In this model you are the bank, though you are using your own money instead of money that is deposited to you. You choose which people to loan money to and take the risk that they won’t pay you back. In return, you keep the large portion of interest and pay the platform (in my case Lending Club) a small portion of the interest for setting up the payment plan and gathering the loan applications and information.
Sounds great but what is the catch? The catch is that there is a very real possibility that some people won’t pay your loan back. In that case you lose the money that you had loaned out for good. If the people taking the loans do not pay them back then they suffer collections calls and ultimately a destroyed credit rating making it very hard to get loans in the future.
As the lender, you can lend out money to “less risky” clients to try and minimize your risk. Peer-to-peer lending platforms give you much of the same information that banks get when choosing whether to loan money to someone. You get to review some of their personal information such as their credit score, job title, monthly income, current credit balances, housing status, length of time on job, and many other attributes. You platform then grades the loan based on this information and gives them the interest rate that their loan will be. Lending Club literally uses letter grades “A” through “F”. This allows you to choose the amount of risk vs. reward that you are comfortable with in your account.
Peer to Peer lending is still a rather new way to invest outside of the stock market but it has become one of the best parts of my retirement portfolio.