When it comes to investment, a lot of people only have a general idea when it comes to what we’re talking about. Sure, the goal of any investment is to generate profit or grow your wealth over the course of time but the way in which this is done differs from case to case. Nonetheless, assuming that every investment is a story of its own is also quite inaccurate. There are some investments that are similar in fundamental ways, which is why they often get grouped into a phenomenon known as an asset class.
In general, there are three main asset classes. First, you have equities, which are more commonly referred to as stocks, cash equivalents. Finally, you have a fixed income (primarily bonds). For the purpose of this post, it is important that we understand why investing in bonds is so appealing. First of all, bonds consistently provide income and when it comes to something as important as investing your money, you need to understand that consistency and reliability are incredibly important. Second, they give you a chance to preserve principal (even during a financial crisis), lastly, they possess so many tax advantages.
Previously, we’ve mentioned that there are three main asset classes. This too is not necessarily correct. There is also a fourth type of asset class known under the umbrella term alternative investments. These include a plethora of asset types like real estate, commodities (like precious metals), hedge funds, private equity or even art. Now, one of them, by far, most important alternative investments is the so-called peer-to-peer lending. Here’s what you need to know about it, as well as why is it so important for your investment plan.
1. The diversification of your investments
The first important thing you need to understand is the importance of the diversification of your investments and why does it matter. You see, as the situation in the business world, as well as the political landscape (both locally and globally), evolves, this affects the value of your assets. Fortunately, it affects them in different ways, which allows the economy to work even when it’s at its most vulnerable. For instance, even during the major crisis like major market crashes, people who had their investments in various types of assets had a much better chance of staying afloat than those who put all their eggs in one basket.
For instance, the same major occurrence in the world may make the value of stocks grow, the value of bonds drops and be completely indifferent to cash equivalents. In the majority of scenarios, the news will give mixed results for alternative investments, seeing as how they are a miscellaneous category, to begin with.
As always, when the risk is highest, the return is the greatest. For instance, stocks have the highest chance of generating the greatest reward but are also the riskiest and, as such, pose a significant threat to losing all your money. After all, the company where you own stocks may fail drastically, thus bringing their value substantially down. This is why investing in the fixed income asset class is so appealing, seeing as how you don’t have to wait for a number of years if the company will do great or not. Every year (for a given number of years), you get a part of your return back.
A similar scenario happens in a peer-to-peer lending scenario, which is why it’s important that you consider it as a legitimate option.
2. What is peer-to-peer lending
By this point, the majority of you are probably asking a single question – what is peer-to-peer lending. Imagine a scenario in which there’s a person who needs a loan in order to execute a business idea or just need a personal loan. Their first instinct would be to go straight to a bank and apply for one. However, there’s no guarantee that the bank would be willing to approve you for a loan either due to your lack of collateral (if we’re talking about a secured loan option) or a low credit score (if it’s an unsecured loan that we’re talking about). Also, even if you do get approved for a loan, the chance is that the interest rate will be so high that it will simply not be worth it.
This is where peer-to-peer lending comes in. First of all, they work via a specialized peer-to-peer lending platform which offers simplicity, security and an incredible insight into who they’re giving the money to. This doesn’t mean that personal information of the borrower is compromised but only that the lender gets to see what their money is supposed to go towards. For instance, a person A may want to buy a car, a person B may need a home repair loan, while a person C may need a loan to start a new business.
What this platform does is merely provide the lender with an insight that will help them decide which of the people in question they can lend their money to. Once again, like with any other investment, you can either stick to the safer investment with a lower return or you can choose to accept higher risk in order to get a higher interest rate. In order to remain profitable (seeing as how the platform is the business of its own and is in it for profit), it takes a cut (a fee) as their fair share for facilitating the deal.
3. How does it work
Perhaps the most important piece of the information that you are interested in is the very model or how this works. Well, it can all be described through a simple six-step process. First, a borrower applies for a loan online (the fact that it all works online is one of the most important factors). Second, there’s a waiting period for conditional approval which takes less than 30 seconds. On its own, this would be enough to prove the superiority of this system (when compared to traditional application model) in more than one way. Then, the loan is listed on the marketplace and the people start investing.
People make these investments every single day and the amount of money invested sometimes go as low as $25 to $50. Still, the volume of these loans more than makes up for any financial needs of the borrower. Keep in mind that borrowers tend to pay people back with interest (which is still lower than the one they would get with the bank). All of this results in investors earning a fixed interest return.
4. The advantages of peer-to-peer lending
The next thing you need to understand is the fact that your P2P lending brings numerous advantages, to everyone, which is what makes them so popular to begin with, however, these benefits can be split into two major categories. First, you have the benefits to borrowers and second, you have advantages to lenders.
When it comes to borrowers, they first gain access to the money in a quicker, simpler and more direct way than if they were to go through a credit union or a bank. Second, they get a much lower loan interest rate, seeing as how the P2P lending platform itself takes a smaller cut than the bank. This is only natural, due to the fact that it’s a smaller business structure with substantially smaller running costs that it needs to cover (we’ll return to this in a minute). Third, you have the transparency, seeing as how the borrowers are familiar with all the factors that go into this deal. This allows for a much more efficient decision-making process.
As far as the advantages for investors go, first, it allows people who have the money in question access to high risk-adjusted returns. Traditionally, this privilege was only reserved for the institution such as banks and major trade unions. However, lenders are not restricted to massive investments. In some instances, they can choose to lend as little as $25. The second advantage is the same type of transparency that you get from P2P lending – you get to pick your loan and know (to a degree) who you’re lending your money to. The credit profile data you get is instantaneous, which means that checking your borrower doesn’t involve a complex bureaucratic process that it normally would.
One more thing worth mentioning is the fact that P2P loans are one of the alternative fixed income classes assets with the highest total return per annum (toe to toe with equities and residential property). In other words, for those still on the fence, all the advantages are more than apparent and transparent.
5. The risks
Another thing we need to discuss is the fact that there are certain risks when it comes to P2P lending. First of all, the concept itself is still relatively new and, as such, it’s quite crude. This means that a proprietary-risk scoring model isn’t as accurate as you would like it to be. Also, the fact that the concept is relatively new, means that there’s no long operating history that could potentially offer people the reassurance they so desperately need.
The next thing worth discussing is the issue of trust. You see, the very concept of internet lending is both faceless and paperless (there’s a complete absence of face-to-face interactions), which makes a lot of people uncomfortable, believing that there’s a risk of it all being just an elaborate online hoax. The problem, nonetheless, lies in the fact that people forget or refuse to do the research of how many times have major banked failed or scammed their clients. We’re not saying that this makes the likelihood of a hoax into a positive thing only the fact that sticking to a model just because it’s more… well, traditional, isn’t necessarily as rational as possible.
To be completely fair, some of these fears are not unfounded, seeing as how in previous years, there has been a number of completely fraudulent application that have managed to tarnish the reputation of the industry in the eyes of many.
What you need is to simply accept the mindset that every investment comes with a risk of its own. Once you get this out of the way, you will be able to make a fact-based decision. After all, whether or not you’ll get disappointed depends on one thing and one thing alone – what is it that you expect.
6. P2P as the future of loans
In one of the previous sections, we’ve mentioned the fact that P2P platforms run a smaller operation than banks, which allows them both smaller overhead and a quicker respond. Why? Well, simply because they can afford it. Just think about the fact that, unlike banks, P2P platforms do not actually need to have physical branches. This means that their staff doesn’t have to be as numerous, as well as the fact that they don’t have to pay a lease and the utilities for every branch that they own.
The biggest cost-saver, however, is the fact that these P2P platforms nor the originating banks have to carry these loans on their books. This exempts them from having to comply with bank capital requirements, which is a huge money-saving phenomenon that makes a world of difference.
The very last thing you need to understand is the fact that an alternative fixed income asset class is definitely something that you need to consider investing in. After all, the diversification of any kind is always a good idea. Seeing as how this form of growing your wealth is quite unique and so much different from the rest of these income classes it gives you an additional layer of financial insulation when it comes to the security of investment. Also, due to all the benefits listed above, it’s crucial that you understand the fact that in order to get involved in the investment of any kind, you need to do proper research on the topic. We hope that this guide helped bring you at least one step closer to this.