Most of us know that lending money to friends and family members rarely results in a full repayment from the person that you lend money to. Loans to friends and family members are much more frequently delinquent because the borrower believes that the friend or family member has some sort of obligation to help them.
Peer-to-peer lending is essentially the same thing as loaning money to a friend or family member. You’re lending money to individuals just like you would loan money to friends and family members, but investors in peer-to-peer lending firms, such as Lending Club, can average anywhere between 5% and a 15% rate of return. Some would argue these numbers, but there are investors on Lending Club that have been making these rates of returns consistently. Why does peer-to-peer lending work when loaning money to friends and family doesn’t work?
There are a couple of key reasons for this. The first is collections. If the borrower doesn’t repay their loan or goes into default, they will likely have a collector calling them and reminding them of their obligation to pay, at least, with Lending Club, they will. The borrower’s credit score will also get dinged, providing another incentive for borrowers to get back current on your loan. When a friend or family member, there’s no consequences to their credits core and you probably won’t be as diligent about collections as Lending Club would be.
Peer-to-peer lending works also because of diversification. When you loan money to one friend, it’s a hit or miss situation as to whether or not they’ll repay. When you put money into Lending Club or Prosper, you’re likely to invest in dozens of different loans. That way, if one of your borrowers does not repay, you’re only out a small fraction of the money that you lended out to begin with. One key strategy that many lending club investors use is to spread their money across as many different loans as possible.
Peer-to-peer lending firms such as Lending Club are much more analogous to a credit card company lending money to an individual than one individual loaning money to a friend. They are both unsecured loans to an individual, but the primary difference is the source of the funds.