The Pros and Cons of Peer-to-Peer Lending as an Investment Strategy
The last few years have seen peer-to-peer lending become a viable alternative investment strategy. This innovative form of lending allows people to borrow and lend money directly from and to each other, without the need for banks or other financial institutions. It is important to appreciate that P2 P lending is not without its challenges as with all other forms of investment. In this article, we will look at the opportunities and threats of peer-to-peer lending as an investment vehicle to help you, the reader, make more informed decisions.
What is Introduction to Peer-to-Peer Lending?
Peer-to-peer lending platforms started in 2000s and ever since they have disrupted the banking and lending models. These platforms have come up with a model that has directly connected borrowers and lenders through an online platform to provide funding without the use of other financial institutions. As a better option than the conventional banking, P2P lending provides a way for both the borrower and investor to get what they want from the investment – high rates for the investor and cheap funds for the borrower.
The Pros of Peer-to-Peer Lending
1. High Potential Returns
The chief advantage of peer-to-peer lending is the high returns that it offers. Compared to other savings products like accounts and bonds that offer low interest rates, P2P lending can provide higher returns, with some platforms offering annual interest rates of 5% to 10% or even more. This makes it an attractive form of passive income for investors.
2. Diversification
P2P lending provides investors with a way of diversifying their portfolio because they can invest in several loans. Thus, by investing in small amounts in several borrowers, the investors can avoid the consequences of a single borrower’s delay or default. Diversity is a rule of investment that has been recognized to minimize the effects of a single loan loss.
3. Availability of Creditworthy Borrowers
Most of the P2P lending platforms are very strict in approving loans to only those with good credit records. These platforms usually use sophisticated techniques including algorithms and credit scores to assess the credit risk of the borrowers and reduce the likelihood of default on the loans.
4. Transparency and Control
Peer-to-peer lending investors are provided with a high level of transparency and control over their investment decisions. This is unlike other forms of investment where the user is not always informed on how the money is utilized; P2P lending allows the investor to choose the borrower. They can examine the borrower’s details, the purpose of the loan, and the risk classification of the borrower before deciding on the investment.
5. Passive Income Generation
One of the most attractive aspects of peer-to-peer lending is the ability for investors to generate passive income. Once an investor makes their investment, they can sit back and relax while they receive regular interest payments. This steady income can be quite useful for people who want to increase their income or guarantee themselves some money in retirement.
The Cons of Peer-to-Peer Lending
1. Default Risk
The major challenge of peer-to-peer lending is the default risk. Despite the fact that there are borrower screening processes in place, there is always the probability of the borrower defaulting on the loans. This may mean that the lender loses the principal and the interest and this calls for the investor to assess the risks that are associated with each loan and try to diversify so that in case of default of one or two loans, the loss is minimized.
2. Lack of Regulation
Traditional financial entities are not as regulated as P2P lending platforms. This is because while it facilitates innovation, it also means that investors may have limited options in the case of platform failure or fraud. Hence, it is crucial for the investors to select the reliable platforms which are financially sound and have transparent working.
3. Lack of Liquidity
Investing in peer-to-peer lending can also be somewhat illiquid when compared to other forms of investment. Once the borrower receives the funds from the investor, then getting the money back can be a difficult process until the end of the loan term. Some platforms may have market for buying and selling loans, but generally liquidity is poor and investors can only get their money back when the loan terms are due.
4. Platform Risk
This platform risk is something that investors face when they participate in peer-to-peer lending. Should a platform close or go into liquidation, investors may not be able to get their funds back easily. For this reason it is important to check and go for platforms that are well known, financially strong and have good risk management measures in place.
5. Lack of Personal Connection
There is a major limitation with peer-to-peer lending and that is the lack of a direct link between the lender and the borrower. This is because while traditional lending has more opportunities for lenders to meet or even interact with the borrowers they are funding, P2P lending rarely provides this opportunity as lenders cannot fully assess the character of the borrowers they are funding. This is a downside for investors who like to have a personal connection with their investment options.
Conclusion
It is an innovative investment strategy with the prospect of high returns, diversification and passive income. But it also has its potential risks, which include the risk of default, the absence of regulation, illiquidity of assets, platform risk, and the lack of correlation between the lender and the borrower. For the prospective investors, it is crucial to carry out thorough analysis of the investments, spread the risk across several investments and select reliable online marketplaces. Therefore, P2P lending can be considered as a potentially profitable asset for increasing the diversification of investment portfolio. In this regard, it is possible to state that peer-to-peer lending can become a relevant and reasonable addition to the investment portfolio but not the only one. When considering the potential benefits of P2P lending, there is a chance to make a decision that is informed by knowledge and may yield the advantages that can be gained from P2P lending.
