This video and guide will start you on p2p investing and how to invest in peer loans to earn high yields and lower your investment risk

P2p investing in peer loans is a popular topic lately and there are a lot of questions from new investors. The new p2p asset class promises higher yields than bonds and lower risk than stocks. The process of p2p investing is easy and accessible to nearly everyone.

What most people don’t realize is that there’s really nothing new about peer loans as an investment vehicle. Banks have been making trillions from lending for millennia, p2p investing is just the evolution of lending directly into the hands of the investors. Check out the video and detail below for the basics on peer lending and how to invest in peer loans.

P2P Investing and How to Invest in Peer Loans

Last week’s video, What is Peer Lending, will give you a basic understanding of the revolution in online loans. This week we’ll look at one side of the industry from the investor’s perspective. Next week, we’ll look at the other side from the borrower’s perspective.

Until peer lending, banks acted as the middleman for investments in loans. Banks would underwrite a personal or business loan and then sell the rights to payments to a brokerage or investment firm. The bank would continue to collect payments but would send them on to the investment firm. The broker would then package a bunch of loans together and sell pieces off to investors according to their own risk and return needs.

The two largest peer lending websites, Prosper and Lending Club, manage a marketplace of loans – much like Amazon is a marketplace where people sell consumer goods. After a verification process, borrowers post their loan request on the sites. You browse loan listings and select those which look like good investments. You can invest from $25 and up in as many loans as you like. The website collects the payments each month and deposits your share into your p2p investing account.

The only difference is that investing in traditional loans would mean sharing your returns with the bank and the broker middlemen.

How much can you Make P2P Investing in Peer Loans?

The seasoned return on peer loans through Prosper of 9.3% has beaten the ten-year average of 7.6% on stocks of large companies (S&P 500) and is nearly double the 4.9% return on the ten-year government bond over the same period.

While it’s possible to earn much higher returns through p2p loan investing, an interview with one investor revealed his strategy for returns of 14% over the last several years, returns will likely decrease a little in the future. Estimated returns for recent loans are 6.9% though you can get as high as 10.2% for loans from the high-risk category.

The reason returns have decreased is mostly because of low interest rates for loans (deleted). Historically low interest rates have pushed down rates for all bonds, something investors really can’t do much about. Even since the Federal Reserve increased its benchmark rate in December, rates on the ten-year Treasury bond have come down half a percent on sluggish global growth. Low interest rates are here to stay and that is going to affect all investments including p2p investing.

Are there Risks to Investing in Peer Loans?

As with any investment, there are risks in peer lending as well. Most of the risks are the same you’d find in any investment class and easily manageable.

Nearly every peer lending investor I talk to has fallen for this first risk, chasing high returns without considering their risk tolerance. You’ll see from the table above that the risk-return tradeoff works within an investment class as well. P2P loans to high risk individuals pay a higher return but see higher defaults as well. A lot of new investors see the potential for double-digit returns and put all their money in these categories. The investor starts to freak out when loans start defaulting, even if the portfolio return is still around the category’s average.

Make sure you understand your investment risk tolerance with the ten questions we looked at last week. Investors that want a very stable portfolio with few defaults should stick with stronger credit rating borrowers. Investors that can handle a little volatility and want higher returns can feel comfortable with higher risk category borrowers.

Another risk in peer lending investing is understanding the concept of diversification, both across categories and with the number of loans you need. Investing in just a few loans means that a default in one could mean a sizeable loss for your portfolio. Investing in more loans means that losses in one or a few loans will mean less to your overall return.

The difference in p2p returns for different size portfolios is almost entirely diversified away by 200 loans in a portfolio while you will still see a lot of volatility for p2p portfolios of less than 100 loans. I recommend you hold between 100 and 200 loans at all times, investing regularly in new loans to cover maturity of older loans.

You do not necessarily need loans from every p2p risk category, though you will want to invest in risk categories that match your risk tolerance and need for return. Investing in many loans across the two or three higher risk categories will diversify your portfolio across those categories. If you can handle a little more volatility, there really is no reason to invest in the safest categories and you will enjoy higher returns. I generally keep my investment within the C, D and E categories.

What is the Process to Invest in P2P Loans?

Check out an earlier post that reviews the two largest peer lending sites, Prosper and Lending Club for the basics on each. Fees and the process are similar on each. These are the only two P2P investing sites open to non-accredited investors, those with less than $1 million net worth.

The actual process for investing in peer loans is fairly simple and straight forward. Opening an investor account on Lending Club takes about five minutes requiring your contact and bank account information. Once you’ve funded your investment account, it is time to look at different loans on the site. Borrowers are ranked on a scale between AA to HR according to their credit history and other loan details. You can also search for loans that fit certain criteria and may have a lower chance at default.

There are upwards of 40 p2p criteria that you can select or change to find the loans in which you want to invest. Most will probably not matter much in your ultimate return on your peer loan portfolio but there are some that have helped to lower risk and increase return. I like to invest in borrowers with no credit inquiries in the last six months and with a debt-to-income of less than 25 percent. Selecting higher-risk p2p loans with these two criteria usually means borrowers that will pay higher rates but are not necessarily in financial trouble.

Looking through p2p loan listings, you can invest from $25 and up in loans that meet your criteria. Once the loan is fully funded by investors, the borrower gets their money and you should start seeing payments show up in your account in less than two months.

Lending Club and Prosper offer a Quick Invest feature where you set your loan criteria and the platforms will automatically select those that meet the requirements. You decide how much to invest in each and then approve an investment in the entire portfolio all at once. It takes some of the fun out of looking at each individual loan, basically becoming a loan officer, but can make the process easier.

Since p2p loans gradually pay off over three to five years, you will want to set regular times to reinvest your money. The payments on loans are a nice return but you will earn nothing on that money until you reinvest it into another loan.

The peer lending platforms have made it extremely easy to invest in peer loans but there is still a process to learning which loans are right for you and how to select them. Just as with your stock or bond portfolio, investing is a life-long venture and there’s no need to rush into things before you have a grasp of how the process works.