Peer-to-peer (P2P) lending has exploded in popularity in recent years as an alternative source of financing exclaims Bahaa Abdul Hussein. P2P lending provides more options and better rates than traditional lending by directly connecting individual lenders and borrowers online. However, P2P lending does come with risks that both lenders and borrowers should understand. Here are some tips to mitigate those risks:

For Lenders

  • Diversify your investments – Don’t put all your money with just one or two borrowers. Spread it out across multiple borrowers to minimize default risk. The more you diversify, the more your risk is reduced.
  • Set lending criteria – Many P2P lending platforms allow you to set criteria for borrowers manually you will lend to, such as minimum credit score. Set strict criteria to only lend to borrowers less likely to default.
  • Review borrower details – Don’t just look at ratings. Thoroughly review each borrower’s income, debts, credit history, and other details to assess risk. Avoid borrowers with red flags.
  • Use an IRA – Open a self-directed IRA to invest in P2P lending. This shields your returns from taxes and limits your losses if borrowers default.
  • Invest in short-term loans – Loans with terms of 3 years or less have lower default rates. Prioritize short-term loans in your portfolio.
  • Automate investing – Use automated tools on P2P platforms to automatically distribute your funds across pre-set criteria to remove emotion and speed up diversification.
  • Withdraw payments – Withdraw all repayments and interest as soon as possible to limit loss exposure if a borrower defaults. Don’t automatically reinvest payments.

For Borrowers

  • Improve your credit – Good credit lowers your rates and improves lender confidence. Check your reports and fix any errors. Pay down debts and avoid new inquiries.
  • Use a co-signer – Adding a co-signer with better credit improves your chances and rates. Ensure your co-signer understands the obligation.
  • Provide details – Maximizing details on income, employment, assets, debts, business, plans for the loan, etc., reassures lenders and may improve your rates.
  • Start small – First-time borrowers should borrow small amounts, then build up to larger loans as they establish repayment history.
  • Pick shorter terms – Opt for terms of 3 years or less. Short terms have lower rates and reduce the risk of financial circumstances changing.
  • Automate repayments – Set up auto-pay from your bank account so you never miss repayment dates that damage credit and relationships with lenders.
  • Pay early – Making extra payments to pay off the loan early saves on interest and builds a positive history with lenders.
  • Communicate issues – If you anticipate missing payments or repayment issues, proactively communicate with lenders to seek alternative arrangements.
  • Build relationships – Develop ongoing relationships with lenders you’ve paid back promptly to gain access to more favorable future loans.

Conclusion

P2P lending can be profitable for lenders and provide affordable financing for borrowers when done responsibly. By mitigating risks through diversification, prudent lending criteria, short terms, automation, good communication, and other best practices, lenders and borrowers can have successful experiences. Ensuring you understand the risks goes a long way toward avoiding or limiting any potential downside.

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