Peer to peer lending is a trend still gaining momentum. The Average Joe has probably never heard of it before and might be a bit skeptical about its promise as an investment method.
While there is much to be said in favor of peer to peer lending, there are also some legitimate concerns that stop people from opening an account.
Whether you already have an active peer to peer account or are just learning about it, knowing the common pitfalls associated with this type of investment can help you avoid costly mistakes.
Not All States Allow Peer to Peer Lending
First things first: you might be disqualified from participating in peer to peer lending based off of where you live. Each state has its own rules and regulations regarding peer to peer lending.
To make things even more complicated, you may be barred from using certain lending platforms based on your state and whether you intend to borrow, invest or trade.
The two most popular peer to peer lending platforms are Prosper and Lending Club. If you cannot use one, you can probably use the other. For example, Prosper is open to borrowers from every state except Iowa, Maine and North Dakota. However, borrowers from Maine and North Dakota can use Lending Club.
Borrowers in Iowa are out of luck when it comes to either platform and also cannot invest using Prosper. However, they are welcome to invest and trade on Lending Club.
Before you get too excited about peer to peer lending, it’s best to make sure it’s actually legal where you live. You may also need to be careful if you move to a new state.
The Minimum Investment Is Often Too High
The idea behind peer to peer lending may appeal to you, but the practicality of it may not. The truth is that many would-be lenders are turned off by the platforms’ minimum investments, which are often between $1000 and $2000.
Most people spending that much money have to do so carefully, and have to save up for several months to reach that dollar amount. And for an investment method that seems riskier and less prosperous than a savings account or stocks, it doesn’t take much for potential lenders to hold on to their hard-earned cash or to invest it elsewhere.
Unfortunately there’s no real way to avoid this problem. If you don’t have the money for a minimum investment, then you simply don’t have the money. However, investing is a great way to earn passive income, so spend some time saving up enough money for the minimum investment. Perhaps keep it in a savings account until you feel confident that you won’t need to dip into it. At the same time, learn how to be a smart peer to peer lender so that your investments will be a success.
Peer to Peer Investments Get No Tax Breaks
Unlike stock market investments, which have a tax rate of 15 percent, peer to peer lending is taxed the same way as income derived from, for example, your savings account. This could mean you end up having to pay a 30 percent tax rate on peer to peer lending, which certainly makes it seem like a sour proposition.
Tax-incentivized IRAs can help take some of the strain off of your bank account come tax season, while still allowing you to participate in peer to peer lending.
Filing taxes can give just about anyone a headache, even accountants. Taxes associated with peer to peer lending are no exception. Expect a learning curve, or to find an accountant who has experience in this niche.
How Does Peer to Peer Compare to Traditional Investing and Stocks?
When comparing peer to peer lending to traditional investments or stocks, it’s important to remember that there are risks inherent in all kinds of investments. However, there are certainly some things to be aware of before you begin your peer to peer lending journey.
For example, the loans you make through peer to peer lending platforms are not insured. This means that if the borrower defaults on the loan and is unable to pay you back, you don’t have recourse. Neither the government nor an insurance company will pay you what you are owed.
You can avoid most serious consequences by diversifying your loans. In other words, start by lending $25 or $50 at a time to different borrowers. If one or two default, you won’t be financially devastated.
You may also be more interested in lending through Lending Club rather than Prosper if this concerns you, since Lending Club pre-screens borrowers to ensure good credit. Prosper, on the other hand, has a more open market.
The return rate on peer to peer loans is typically lower than on stocks, but the peer to peer market is more stable and is growing all the time. You can expect a healthy 7 percent return on investment each year, on average, through Prosper or Lending Club.
Peer to peer lending is a relatively new way of investing, and it’s often more meaningful since the intermediary between borrower and lender is practically non-existent, since you get to choose who you lend money to. Being well-informed is the key to becoming a successful investor, no matter which method you choose. Whether you’re looking for diversification opportunities or are just dipping your toe into the waters of investment, peer to peer lending is an exciting new way to earn passive income while also helping your community.