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How to Make a Passive Income through Peer to Peer Lending

Updated on February 21, 2012
Prosper is one example of a peer-to-peer lending site.
Prosper is one example of a peer-to-peer lending site. | Source

My personal experience with peer-to-peer or social lending

For the past year, I have been a lender with Prosper, a peer-to-peer (P2P) or social lending company. I have invested a total of $1,000 with Prosper and have purchased 7 loans through this firm. In my time with Prosper, I have earned nearly $110, or about 11%, in interest. This has beat any kind of interest I would've earned had I invested my money in a traditional bank account, or even a money market account. In addition to my stock portfolio, I look at P2P lending as a great way to diversify my investments and make a good amount of passive income to boot.

There are two main P2P lending companies that I know of and have worked with in the past year: Prosper and Lending Club. Both companies operate online, require that you connect to them via your personal bank account, and that you have no outstanding legal debts or back taxes to pay. You must provide your social security number and tax return information as well. Once you have set up your account with either Prosper or Lending Club, you can start perusing the various loans available for purchase. The minimum partial purchase amount is only $25- although you can also purchase the entire loan too. There are many types of loans available, and for all kinds of purposes: debt consolidation, vacations, weddings, home improvement, business purchases, etc. There are also many types of interest rates placed on these loans, from a meager 5.98% to as much as $16.98%. These interest ranges have much to do with the credit rating of the person as well as the purpose of the loan. For example, a $25,000 personal loan taken out for debt consolidation by someone with a 730 credit rating is going to receive a much lower interest rate than a $25,000 personal loan taken out for a vacation by someone with a 650 credit rating.

Peer-to-peer lending vs. traditional lending

You might not know that obtaining a private loan through a traditional lending institution, such as a bank, for debt consolidation or home improvement can come with a very high interest rate. Even for someone who has an excellent credit rating of 750 or above, a personal loan can carry an interest rate of 15% or higher. This is in spite of the bank advertising its loan interest rates as being 5% or fewer. Why does such a rate discrepancy occur?

The reason has to do with how traditional lending institutions perceive personal loans, which are often called unsecured loans. If you wish to obtain a loan for debt considation, bill payment, home improvement, or the like, you have no collateral with which to secure that loan. On the other hand, for a more traditional loan like a mortgage or a car loan, you secure your loan with collateral such as your house or car. In the event that you default on your loan, your house or car will be held by the bank until you pay all your delinquent loan installments.

Because of bank failures and subsequent bailouts, it has simply become more of a challenge to obtain a personal loan. Interest rates on personal loans have also risen substantially. As an answer to the difficulties incurred with traditional lending, various peer-to-peer or person-to-person (P2P) lending groups have started. In some cases, they are referred to as social lending groups.

These groups operate online and provide, in essence, online loans. The groups in question are composed of ordinary people -like yourself- who pool their funds together and provide loans to other ordinary people -like yourself. The interest rates incurred with P2P loans are far lower than those of banks or other lending institutions and are paid through monthly installments by the borrower. Finally, the loans provided are generally short-term loans, lasting from 3-5 years in duration. At the end of the borrowing time period (e.g., three years), all borrowed funds are returned to the lender.

A summary screen of Prosper loans, or notes
A summary screen of Prosper loans, or notes | Source

How do you become a lender with P2P lending clubs?

To become a lender at a P2P lending club like Prosper, you will need to first supply your personal information like your name, address, phone number, etc. Then, the site will ask you to provide your social security number, bank account number, and tax return information. You will be asked if you have any outstanding debts with the IRS and if you are subject to back taxes and other witholding. Once you have verified your bank account and other personal information, you will be ready to start funding your lending club account through your bank account.

You don't need to start with a lot of money to get involved with P2P lending; in fact, I funded my first loan with just $50. Over time, though, I kept adding more funds, and today my account holds about $1,000. I have this money distributed over 7 loans in total. My earlier loans have paid out a good deal of money for me, since I collect roughly 1% per month on them. As I mentioned before, the interest rates I get through Prosper definitely beat the 0.5% that most of my bank checking and even savings accounts give. It simply makes little sense for me to keep the majority of my cash in bank accounts that can't even keep up with the inflation rate.

What if you wish to borrow money through P2P lending?

P2P lending companies such as Prosper and Lending Club work with both lenders and borrowers. To become a borrower, you will need to fill out a lot of the same information as you would to become a lender, namely your personal information, social security number, income tax information, and income level. Additionally, you will be asked how much money you wish to borrow, the loan term (3, 4 or 5 years), the intent of the loan (e.g., debt consolidation), your actual occupation, and why you are a good candidate for this loan.

Once your personal information has been verified, your initial loan request will be released to your peers for funding. This will take anywhere from 2-4 weeks, and the total time required will be determined by how "likeable" your loan request is, how easy it is to verify all your provided information (such as your income level), and also by your credit rating and credit score on the lending club site. If you are currently delinquent on any loans, this information will also be posted to your profile and may affect how quickly you are funded.

Lending Club is another peer-to-peer lending site that allows individuals to borrow money for business start-up funding, debt consolidation, etc.
Lending Club is another peer-to-peer lending site that allows individuals to borrow money for business start-up funding, debt consolidation, etc. | Source

How is your loan interest rate determined?

Social lending clubs like Prosper and LendingClub charge a given interest rate on borrowed funds, with most of the interest going to the lenders and a small remainder going to the company handling the loan (e.g., Prosper) as its service fee. Individual loans will carry different interest rates depending on your credit score, your debt to earnings ratio, your current revolving credit, and the purpose of your loan. Most lending clubs will also assign you their own credit score, so to speak, based on additional factors that will be calculated when you start applying for a loan.

Overall, however, P2P lending clubs charge a much lower interest rate than banks or payday loan stores. If you have an excellent credit score (800+) with a site like Prosper, for example, you might pay a total interest rate of 8%. If your credit rating is considered good (700+), you are typically charged a total interest rate of 10%.

Is P2P lending risky?

As a borrower, you do not take on much risk by having your loan funded through a P2P lending club. There is no callateral that you need to provide. Your only risk, per se, is the interest rate on your loan, and whether you may have received a lower rate with someone else. Thus, it never hurts to shop around, both with traditional lenders like banks and with P2P clubs.

As a lender, there is some risk to investing with P2P lending clubs. After all, you are loaning your money to people on whom you depend to pay back the loan through monthly installments. If they fail to pay back your loan in full, your loan goes into default and you may end up losing your money. This is much the same risk that banks take when they lend money, and this is also why lending institutions overall are quite picky about their borrowers.

To mitigate your risk, consider lending your money only to borrowers who have no history of delinquencies, who are currently employed, and who have little revolving credit compared to their level of income. You might also consider only looking at loans from those individuals who have good to excellent credit, or a P2P site score of A or AA. Personally, I've loaned money only to those individuals with a P2P score of A or above even though the interest rates on personal loans with a score of B or below were far better.

Summary

P2P lending clubs are a good alternative to traditional lending institutions such as banks for obtaining a loan. In essence, lending clubs operate on the principle of individuals, like yourself, becoming lenders to other individuals. Furthermore, if you are looking to invest your money and get a decent interest rate on it, you just can't beat the interest rates that P2P lending clubs offer.

Before borrowing from or investing with a company like Prosper or Lending Club, be sure to do your research. Although it's unlikely, as a borrower you might be able to obtain a lower interest rate elsewhere. As a lender, you need to consider the likelihood of borrower default when choosing loans and interest rates.

Would you consider getting involved in P2P lending?

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    • onthegrind profile image

      onthegrind 

      6 years ago from Florida, United States

      Very useful information. I am a LendingClub lender. I have had similar results as you have had with Prosper. I was shocked that I've actually had a few people pay off the loan entirely within a few months. I haven't had a charge-off yet.

      I think P2P lending is a viable way to diversify and possibly get a good return. It can be risky, but like you stated, there are some ways to limit the risk. Voted up, useful, and SHARED.

    • ChristyWrites profile image

      Christy Birmingham 

      6 years ago from British Columbia, Canada

      I was not aware of many of these details. This article is good for anyone wanting a new way to invest who may find themselves in a similar situation to the one you faced. Vote up!

    • profile image

      mikeydcarroll67 

      6 years ago

      I'll have to look at this for myself! I need other sources of income anyway!

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