As peer to peer lending platforms have captured the imagination of investors worldwide, it’s worth knowing how they work and whether they fit into your investment strategy. Before we get into the weeds, let’s first understand what peer-to-peer actually means and what were the driving forces behind the rise of P2P lending sites in Europe.
📜 The History of Peer-to-Peer Lending
The peer-to-peer technology concept was first popularised by music file-sharing networks such as Napster, eMule, and most recently torrents. What peer-to-peer means is that we’re removing the intermediary and regular people are sending files to other regular people.
Applied to peer-to-peer lending, it means that we are lending money to other people who need it for something specific. There is no need for a bank to get involved because the money is flowing directly from loan providers to the people requesting the loans.
The traditional way of getting loans was to go to a bank, describe why you needed the loan, show your assets and submit an application. You then had to wait days or weeks until you receive a decision from the bank. They would offer you the terms, including probably the most important factor which would be the interest rate.
After the financial crisis, many banks became much more restrictive in who they give loans to, especially in certain countries. This left a lot of people and businesses in dire straits as they had nowhere to go to in order to obtain much-needed capital to make important purchases or investments. This also created a situation where many investors in Western Europe (e.g. Germany, UK) were flush in cash, and on the other hand, you had people and businesses in Eastern Europe (e.g. Latvia, Lithuania, Georgia) who were suffering due to the difficulties in obtaining financing.
P2P platforms solved these problems by providing an alternative to banks. Investors now have no borders and can easily invest in loans outside of their countries at very good returns, because there is so much demand. In this way, everyone is a winner. The platforms themselves take a cut when loans are re-sold on the secondary market.
How P2P Platforms Link Investors and Borrowers
Typically you will see different kinds of loans, some with no guarantee and others with some kind of guarantee. For example, if the loans you invest in have BuyBack guarantee, then the highest risk is for the P2P lending platform to go bankrupt, and that can happen because of many reasons – bad management decisions, competition or scam.
Peer-to-peer platforms service the loans and receive payments from the borrowers. Then the received payment is divided proportionally according to the amount of investment between all investors that have invested in the particular loan.
As soon as the borrower whose loan you have invested in repays his loan, you will start receiving payments of both the principal sum and the interest, for the investment period. They will be automatically transferred to your account. You can reinvest the received money in any available loans or request a payout directly to your personal bank account.
Each loan, has a specific date of repayment, so the investor will receive money in his account according to the regularity of payments made by each particular borrower.
🤔 How Do P2P Lending Sites Make Money?
As investors, we should always be very careful about where we invest our money, because as Warren Buffet likes to say:
“The first rule about investing is not to lose money”
Therefore, one of the things I always ask myself when someone offers me some opportunity, is:
“What’s in it for them?
We can, therefore, apply this question to the European P2P lending platforms that we’ve been talking about. How do they make money and what’s the role of all the parties involved in this business?
As we kn0w by now, P2P lending companies or platforms are the intermediaries between l
While in the early days, platforms charged fees to both lenders and borrowers; nowadays I’ve yet to come across a platform that charges any fees to investors/lenders, except on withdrawals or currency conversions. It is simply not good to do so from a marketing point of view. The platforms are better off offering slightly lower rates and thus making money off investors from the spread between the interest rate offered to the borrower and the rate that they offer to the lenders.
Some P2P lending platforms charge flat fees to borrowers. This is is especially true for bigger loans such as business loans that run into high thousands of euros.
For consumer loans, the lending platforms tend to simply charge a margin in interest percentage (they will charge the borrower an interest rate of 25%, while giving a rate of 15% to the lender and keeping the remaining 10% for themselves).
What Returns Can Lenders Expect?
The returns that lenders/investors can expect vary depending on the economic climate. If interest rates are low in general, then we can expect that platforms will offer lower rates as well. This is the current economic outlook worldwide. But 15-20 years ago bank interest rates were very high, so it would not have made sense to invest in P2P platforms when your savings account already rewarded you with 10% returns guaranteed.
Nowadays, you barely find any bank accounts giving you 1% returns, so the returns of 10-15% offered by P2P lending sites are way better in comparison. You can read about my returns on each P2P lending platform in a separate post to get an idea of what to expect.
It is important to understand that such investments are to be considered an alternative investment with a rather high-risk profile. You will most probably have loans that default, but the idea is that the overall returns will eclipse these minor defaults.
Do you have any questions about peer-to-peer lending? I have been active as an investor in the space for the past 5 years and have learned a lot through experience and interviewing some of the people behind the top platforms on my podcast Mastermind.fm.
I believe that questions and discussions are the best way to learn, so I welcome all your questions and will do my best to give you an answer that is helpful. Please go ahead and leave questions in the comments section below rather than sending me an email. In this way, your question and my answer will benefit all the readers.