I believe peer to peer lending remains the most remarkable breakthrough in finance today, but it can be difficult to understand, especially at first. To introduce its concept, it can be helpful to compare it to something we already understand. Let’s talk a bit about digital music.
Digital Music Changed Everything
Digital audio files (like MP3s) changed the entire nature of the way music was made, sold, and listened to. With the advent of the internet and digital music, musicians no longer needed a label (a middleman) like Sony or Columbia to become successful. They only needed a decent studio, public exposure, and plenty of talent. Additionally, people who purchased music no longer needed to get in a car to do so; they could download their favorite artist’s newest album within minutes of it being released online.
I remember downloading my first MP3 (Coldplay’s song Yellow). I could not believe how easy it was. Within minutes I had crystal clear music playing out my computer speakers.
Big changes accompanied digital music. First, since there was suddenly so much stuff available, the price of an album went down. Second, the record companies lost a lot of money and are still struggling today. Finally, the possible listening experience of everybody nationwide got better. No longer were people forced to choose from one of five radio stations or browse a limited collection of fifty CDs in the new-release section of their local music store. Instead, everybody had access to their particular style of music. True, there was suddenly a lot more poorly-produced music, but there was also a ton of excellent stuff that previously had no exposure.
This is a digital movement: prices drop, the middlemen shrink, and everybody has access to better goods. The idea of peer to peer lending is similar to the arrival of MP3s: it’s digital, it circumvents the labels (banks), and it is of higher quality that what previously existed.
Peer to Peer Loans: In A Paragraph
Imagine somebody needs money to start a business or pay some bills. They could approach a platform like Lending Club or Prosper and apply for a peer to peer loan. In order to be considered for this loan, they would have to submit information like their social security number (to run a credit report) and employment status. Any false information or bad credit history and an application is denied. If a borrower’s application does get accepted, the requested loan is added to the platform’s list of available requested loans. The borrower then has two weeks for lenders throughout the country to take a look at the loan and decide whether to invest. If their requested loan gets enough funding from investors within this period, it is issued. The borrower then makes monthly payments on this loan until it is repaid, and the lender collects these payments minus a small fee to the platform.
Lending out Peer to Peer Loans
Those are the basics. As a potential lender, you are the person who goes onto the platform and has the opportunity to invest in these requested loans. To do this, you go to the LendingClub.com or Prosper.com websites and submit an application to become a lender. Note: there are some restrictions, and some states do not yet allow lender accounts, so check these sites to see if your state is listed. After you open an account with a platform and transfer some funds into it, you can begin browsing the platform’s long list of available loans. This task of choosing loans out of the hundreds or thousands that are available for investment is where new investors can get confused. After all, how can you tell which loans are the best ones?
The short answer is that nobody knows. Every loan on that platform has the ability to default (not be repaid), because every loan has a flesh-and-blood human being behind it – a person whose life is complicated and full of the unexpected. But as you begin to learn about loans, research loan history, and examine the currently available loans, you will be able to determine the best loans for your particular investing strategy.
Lending Club and Prosper have made it easier to separate the loans you prefer by setting up filters (also called saved searches). As a result, selecting the better loans can be quick and repetitive as you become more familiar with the process (note: we will cover filters in part 4). Most successful lenders only need to log in for a few minutes per week. However, nobody started out this way, including myself. I had to take time to become familiar with the platforms and understand which loans were the wisest investments. With a bit of work on the front end, things fell into place.
Tip: Pace Yourself
The best advice I can give you in this starting place is to go slow, be curious, and enjoy it. Learn it for yourself. One of the best things about peer to peer lending is how little money you need to try it out: just $25. You will not be diversified with only one loan, but you should get a decent feel for how the lending platforms work.
Once you have established a rhythm, it is simple to just maintain this habit a few minutes every week. You just (1) go to your account to see if there are available funds and (2) filter the platform for quality loans and choose a few to fund. Pretty simple. People get access to a needed loan and you get a great return on your investment.
In part two we examine the five-step process of peer to peer lending in closer detail.