Instead of turning to big banks, many people are borrowing from -- and investing in -- their neighbors. Known as peer-to-peer lending, this could grow into a $150 billion market by 2025, according to a 2015 report by the consulting firm PwC.
Peer-to-peer lending companies such as Lending Club and Prosper serve as middlemen for so-called P2P loans. Some people come to these marketplaces to request loans for anything from paying down high-interest debt to taking a vacation. Others come to invest in debt, with returns that usually beat the dismal interest rates offered by savings accounts. Here's how borrowers and investors can get the most out of peer-to-peer lending.
5 TIPS FOR BORROWERS
Consider P2P for an unsecured loan.
Borrowers turn to online peer-to-peer platforms because they promise a quick, easy process and low interest rates compared with other sources of unsecured debt. Interest rates start at 5.32 percent through both Lending Club and Prosper but vary by borrower.
Compare origination fees.
Lending Club and Prosper charge origination fees ranging from 1 percent to 5 percent of the amount borrowed. The fee is taken out of the loan amount. In other words, someone who takes out a $10,000 loan with a 5 percent fee will get $9,500 but must pay back the full $10,000 plus interest.
Shop for loan offers with better fees and terms.
Peer-to-peer lending companies use different formulas for repayment rates, and a difference of several percentage points could translate into hundreds or even thousands of dollars in savings. It pays to get a quote from more than one marketplace before agreeing to a loan.
Make sure repayment is manageable.
Borrowers should consider terms such the length of the repayment period. Lending Club and Prosper allow up to five years, for example. The services charge identical fees if payments are more than 15 days late: the greater of $15 or 5 percent of the amount due.
Give yourself a head start.
Having a good credit score and low debt-to-income ratio can result in lower interest rates when borrowing money. Avoiding late payments, keeping credit card balances at or below one-third of the available credit, and refraining from opening credit accounts beforehand can help maintain or increase a credit score
5 TIPS FOR INVESTORS
Test a strategy before locking it in.
Investors can choose to invest in loans one by one or enroll in an automated program that chooses investments based on estimated return. Investors can also create a custom filter to invest automatically in loans that meet their criteria. Filters can be tested at third-party sites such as NSR Platform.
Examine borrower data.
Investors need all the data they can get to create smart custom filters. P2P services screen and rate borrowers and present the loans to investors. Identifying information such as names and Social Security numbers are kept hidden, but Lending Club and Prosper do let investors see borrower data such as annual income, FICO score, debt-to-income ratio, and home state.
Minimize risk with multiple loans.
Investors often put only a little bit of money into each loan -- the minimum is $25 -- so borrowers may be paying back hundreds of people when they make a payment. By spreading their investments over hundreds or even thousands of loans, investors minimize their risk.
Understand the fees on each platform.
Prosper and Lending Club handle investor fees a little differently. Prosper charges an annualized 1 percent of the outstanding principal of the loans in investors' accounts. (Throughout the year, the principal on the loans will go down, so the fee may come out to be slightly less than 1 percent of the original amount.) Lending Club charges investors 1 percent of the payments received, meaning the fee is applied interest payments as well as principal. Lending Club also has a $100 annual fee for investors who have less than $10,000 invested on the platform, although it's waived during the first year with an investment of at least $5,000.
Save money with an IRA or 401(k).
Simon Cunningham, founder of the P2P education and news site LendingMemo.com, says one way investors save money is by using tax-advantaged retirement accounts
-- 401(k)s or individual retirement arrangements -- that let them avoid or delay paying taxes on the money they make. This leaves them with more money to reinvest. According to Lending Club
, investing with a retirement account can lead to increased earnings of $320,000 over 30 years. People who want to invest in a wide range of loans can open two accounts, putting high-risk loans with high potential yield in tax-advantaged accounts and low-risk loans in standard accounts.