Any time you see an opportunity to earn higher-than-average returns on your investment, it should be a given that certain risks will be involved. Peer-to-peer investing works the same way. Here are some of the considerations.
Loans are unsecured and can default
Peer-to-peer investments are in loans made to individuals, which means they carry the danger of default. That risk is even greater because the loans are generally unsecured, so there is no collateral to go after in the event of default. It is conceivable that you simply could lose one hundred pc of your investment on an early-term default. (This is why diversifying across hundreds of notes is so important.)
No FDIC insurance on your investment.
Unlike bank investments, peer-to-peer investments aren’t covered by FDIC insurance. That means you will not be reimbursed in the event of borrower default. You will also not be reimbursed in the event that the peer-to-peer platform fails, although they typically have backdoor arrangements with other institutions to take over the loan portfolios should that happen.
When you buy a certificate of deposit, a Treasury security, or a bond, you invest a particular amount of cash and are paid interest while the safety is outstanding. At the top of the term, you get your original principal returned to you. But that’s not how peer-to-peer investing works. Since you’re investing in loans, and people loans are being gradually paid off within the loan term, the investment will deplete all the thanks to zero at the end of the term. If you are doing not reinvest the payments, and instead spend them, you’ll haven’t any investment capital from that note when it ends. This is a crucial distinction that a peer-to-peer investor might miss.
P2P performance during a recession is an X factor
What is known is that loan performance tends to say no generally during recessions. Exactly how that will play out in the next recession is open to debate.
Up to this point, the only platform that offers a secondary market where you can sell your notes is Lending Club (though some other platforms are using Lending Club for that purpose). And even on Lending Club, that ability is limited. Though it may change in the future, you can only sell a limited number of notes on the secondary market, and those generally must be sold at a discount. As well, you cannot sell a note on a loan that is in default. In this way, peer-to-peer investing is extremely much a buy-and-hold strategy.