[Editor’s Note: The following article is a guest post written for Business Insider.]
It sounds ludicrous when you first hear it: Loan money to complete strangers online whom you have never met and know very little about. Then expect to be paid back, with interest, over typically three to five years.
But peer-to-peer lending, also known as p2p lending, is becoming very popular.
In fact, $2.4 billion in loans were made last year by the two leading p2p lending platforms, Lending Club and Prosper, and that number is expected to more than double this year.
Why the surge in popularity? Here are seven reasons why more and more people are discovering what a good idea it is to invest in our fellow Americans.
1. You are only lending money to prime borrowers.
One common misconception people have about p2p lending is that the borrowers on these sites must be people with poor credit who can’t get a loan elsewhere. This is simply not the case.
On Lending Club and Prosper, all approved borrowers have good credit, with an average FICO score of around 700 — the minimum FICO is 640 to even be considered for a loan.
Most of these borrowers have many options for a loan but have decided to take out a p2p loan because the interest rates are lower than they would have to pay on a credit card.
2. There is a strict and rigorous underwriting process.
Just because a borrower has a good credit score does not mean he or she will be automatically approved for a loan. Many investors are surprised by a rigorous underwriting process that leads to around 90% of borrower applications being rejected by the platforms. Full credit reports are pulled on every borrower, which ensures that only the most creditworthy of borrowers are made available to investors.
3. You get to decide which borrowers you want to invest in.
Every platform grades borrowers based on risk level, with interest rates set at rates commensurate with the perceived level of risk. When building a p2p lending investment portfolio, investors can pick and choose their borrowers one by one or let the platforms create a portfolio based on selected risk levels. Investors get to decide how much risk they are willing to take on.
4. You can invest as little as $25 in each loan.
This is one of the truly great things about p2p lending. Both Lending Club and Prosper allow a minimum investment of just $25 per loan. So, with a relatively small investment, it is easy to build a diversified portfolio of loans. Like any investment, it is important not to put your eggs in just one or two baskets. By building a portfolio of 200 loans or more, the negative impact of any individual borrower default is vastly reduced.
5. An annual default rate of 3-4%.
When most people first hear about p2p lending, they assume it must be very risky with high default rates. But the platforms have done an excellent job of mitigating the risk to investing in complete strangers. The average annual default rate is in the 3-4% range, and investors can even reduce that amount by investing in the most creditworthy of borrowers. For example, an A-grade loan at Lending Club, while providing a lower yield to investors, has an annual default rate of well under 1%.
6. The major platforms make their complete track records publicly available.
Peer-to-peer lending has been built in the spirit of transparency. Both Lending Club and Prosper make their entire multi-year loan history available for download. Investors can analyze this history in Excel or they can use a third-party statistics sites like NickelSteamroller.com, which provides an easy-to-use inquiry tool on loan history.
7. Consumer credit has been one of the highest returning assets classes for decades.
There’s a reason why banks continue to flood our mailboxes with credit card offers. Consumer credit has been one of the highest returning asset classes for decades, and until p2p lending came on the scene, this asset class was reserved only for banks.
Consider these numbers: In the first quarter of 2014, credit card interest rates averaged 13.14% while charge-offs were at 3.29%, leaving a net yield of close to 10%. Today, p2p lending provides the opportunity for everyday investors to, in effect, become banks and earn a high yield by investing in this established asset class.