What to Know When Investing via Peer to Peer Lending

Investing isn’t an easy concept to wrap your head around.

It gets more complicated once you leave the typical investments such as stocks and bonds.

That said, optimizing your investments is key to reaching your financial goals. One method of optimization includes diversification.

Diversification spreads out your risk by investing in different types of investments. This way, you won't have all your eggs in one basket.

Diversification prevents one bad investment from ruining your chances of reaching your goals.

One potential way to diversify part of your portfolio is by investing in peer-to-peer (P2P) lending. If you’ve never heard about peer to peer lending, here’s what you need to know.

What Is Peer-to-Peer Lending?

Peer to peer lending websites run online marketplaces. These marketplaces connect investors with borrowers that need a loan.

The unusual aspect of peer to peer lending is the fact that there are no traditional banks involved. Instead, as an investor, you’ll lend money to individual loans or groups of loans.

How It Works

Here’s how it works. First, a potential borrower applies for a loan (usually an unsecured personal loan) through a peer to peer lending marketplace.

The marketplace screens and categorizes the application based on the risk to investors. They use information such as credit scores and income to help predict default rates.

Potential loans are then made available to investors to view.

Picking loans

Investors can choose to invest automatically based on a strategy they’ve set in place. If you don't like automation, you can also view individual loans and decide which loans to invest in.

In most cases, you won’t be the only person funding a loan, sometimes called a note. Instead, many investors provide a small part of each loan until the loan is fully funded.

Once funded, the peer to peer marketplace releases funds to the borrower.

Earning a return

Then, the borrower starts making payments according to the terms of the loan. Most loans have repayment periods of three to five years.

The borrowers make payments to the peer to peer lending marketplace. The marketplace then takes their cut before sending the remaining amount to the investors.

Peer to peer lending helps investors by allowing them to potentially earn higher returns than they could get by leaving money in a savings account.

Of course, lending money through peer to peer lenders is riskier than an FDIC-insured bank account.

If a borrower defaults on their loan, an investor could lose whatever money has not been repaid.

Investor Eligibility Requirements

Investing in peer to peer loans isn’t available to just anyone. Unfortunately, you must meet a set of requirements to take part in peer to peer investing.

There are actually two different categories of peer-to-peer lending investors.

Small investors

The first is smaller investors. The requirements to be a smaller investor vary by state.

The requirements are called suitability standards.

They require you to have a certain net worth, such as $250,000, or a combination of income and net worth, such as a $70,000 annual gross income and a $70,000 net worth.

Make sure to check your state’s suitability requirements if you wish to invest as a smaller investor.

Accredited investors

The second type of peer to peer investors are called accredited investors. Some peer to peer lending marketplaces only allow accredited investors to invest.

Accredited investors must have a net worth of at least $1,000,000, excluding their primary home.

To waive the net worth rule, you have to have an income of at least $200,000 in each of the last two years. If you’re married, the income rule jumps up to a $300,000 combined income.

Top Peer-to-Peer Lending Platforms

Two of the biggest players in the peer-to-peer lending world are LendingClub and Prosper. Both of these peer to peer platforms allow smaller investors.

That said, other peer-to-peer lenders only allow accredited investors to invest. These include Upstart, Peerform, and Funding Circle.

Unfortunately, not all peer-to-peer platforms are available in all states.

Eligible States for Peer-to-Peer Lending

Platform States Where Investors Can Invest
LendingClub Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New York, North Dakota, Oklahoma, Oregon, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington, Wisconsin, West Virginia, and Wyoming
Prosper Alaska, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Louisiana, Maine, Michigan, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New York, Oregon, Rhode Island, South Carolina, South Dakota, Utah, Virginia, Washington, Wisconsin and Wyoming.
Upstart All states as an accredited investor
Peeform All states as an accredited investor
Funding Circle All states as an accredited investor

Creating Filters to Build Your Loan Portfolio

Once you’ve funded your peer to peer lending account, it’s time to start picking which loans you want to invest in.

Some investors read through the details of every loan until they find the perfect loans. Thankfully, you have another option that is much faster.

Once you have a good feel for the types of loans you do want to invest in, you can set up filters to only display loans that meet your criteria.

For instance, you may only want to invest in loans with certain grades that have had no credit inquiries within the last six months.

Once you enable a filter, all loans displayed will meet your criteria and all others won’t be shown.

Depending on the platform you choose, you may even be able to use custom filters you’ve set up to manage which loans you automatically reinvest in.

How to Diversify

Diversification is key with any investment strategy. It helps to make sure one bad investment won’t ruin your returns.

First, you should make sure peer to peer investing is just a part of your investment strategy.

Only you can decide how much of your investments should be allocated to peer to peer lending.

Even within your peer to peer lending investments you can have a diversified portfolio of loans.

You can decide to limit the amount you invest in any particular loan. This could help reduce your risk of having a single default destroying your returns.

You can also spread out your investments over different loan quality categories. These categories may also be called grades or ratings.

Riskier categories may default more often. However, they usually charge a higher interest rate to offset that risk. Keep in mind, even the least risky loans could default from time to time.

You must choose a diversification strategy that balances your desire for higher returns with the risk associated with higher return loans.

Can You Sell Off Bad Loans?

In general, when you invest in peer to peer loans you should expect to hold the loans for the entire term of the loan.

Most loans have terms that range from 36 to 60 months, so you might be holding on to these loans for quite a while.

Unfortunately, sometimes things come up and you need to sell a loan. You may need to access the money you have tied up in that loan for personal or business reasons.

Other times, you may notice a loan isn’t performing as you had hoped. In that case, you want to get rid of the loan before the borrower defaults.

If you need or want to get rid of a particular loan, you may be able to sell loans you hold. You can do this through Lending Club or Prosper by signing up for a Note Trading Platform run by FOLIOfn Investments, Inc.

As the loan seller, you’ll have to pay a transaction fee equal to 1% of the sale price.

You can also buy loans from others using the Note Trading Platform. This is a great option if you wish to buy loans with a shorter remaining term than the typical three to five-year term.

You can review the loan performance up to the point of the sale to pick loans that meet your requirements.

Tax Considerations

If you get involved with peer to peer lending, it’s important to consider what impact these investments will have on your tax situation.

Remember, every person’s tax situation is unique. That said, these loans will almost certainly make your tax return a bit more complicated.

You should consult with your tax professional to get an idea of how these types of transactions will impact your tax situation.

You may receive income from your peer to peer investments in the form of interest income from loans. You may also receive miscellaneous payments such as late fees.

You’ll receive tax forms, such as 1099-OID and 1099-MISC, which report this information to the IRS.

You’ll be responsible for inputting information from these forms on your tax return. Other options include using tax preparation software or visiting a tax preparer.

You could have loans that were charged off or receive income from loans that were once charged off as bad debt.

If this happens, you could receive a tax form 1099-B.

This form reports the loss from a charged-off loan or income for the recovery of a charged-off loan.

When selling loans on the Note Trading Platform, you will likely receive Form 1099-B.

This form gives you the important tax information from the sale.

IRA Investing

If you’re looking for a tax-advantaged investment, LendingClub and Prosper offer IRAs.

Prosper requires a $5,000 minimum deposit to open a Prosper IRA. They currently offer Traditional, Roth, SIMPLE and SEP IRAs.

While there are annual fees to maintain a Prosper IRA, Prosper will pay the first year’s fee with your $5,000 minimum deposit.

They will pay the annual fee in future years if you reach and maintain an invested balance of $10,000 or more in year two and beyond.

LendingClub also currently offers Traditional, Roth, SIMPLE and SEP IRAs. LendingClub IRAs have annual fees, too.

Just like Prosper, LendingClub may pay these fees if you meet certain requirements.

If you use IRA Services Trust Company as your custodian, LendingClub will pay the annual account fee at account funding on your behalf if you maintain at least a $5,500 or more balance invested in LendingClub Notes within the first 12 months.

If you use STRATA Trust Company as your custodian, LendingClub will pay the annual fee on your behalf if your account has a minimum balance of $5,000 or more invested in LendingClub Notes in the first year and $10,000 or more invest in LendingClub Notes in future years.

Is Peer-to-Peer Lending Right for You?

Only you can decide if peer to peer lending is right for you. You have to balance the potentially higher returns with the higher risk of loss on your investment.

Ideally, you could diversify your peer to peer investments using different loans and loan classifications to spread out your risk.

Even then, make sure to diversify between other types of investments.

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