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Lending as an Addition to Your Investment Portfolio

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These days, the word “investment” gets thrown around too easily, used casually in every other sentence. But what does investment really mean?

An investment is anything purchased with money that is expected to produce income or profit. So let’s say the car you bought will be used to transport products that you sell, the car can be considered an investment.

There are three basic types of investments: ownership, cash equivalents, and lending. Let’s take a closer look at each one:

Ownership investment is the most common type. This includes real estate, business, stocks, and precious items and collectibles such as paintings. Cash equivalents are investments that are “as good as cash,” meaning, they can be easily converted to cash. A good example of this type is investing in money market funds.

Now let’s zoom in on the third one: Lending investment. This type of investment allows you to act like a bank. Having a savings account already makes you an investor because you essentially lend money to the bank. The return is low, but the risk is close to none. Another type is bonds. A bond is a blanket term for a wide range of investment types including treasuries and international debt issues, credit default swaps, and corporate junk bonds. The risks vary depending on each type, but generally, lending investments have lower risk and lower returns compared to ownership investments.

What about Peer-to-peer Lending?

P2P or Peer-to-peer lending has gained traction with investors over the years, probably due to the disappointingly low returns of savings and bonds. In peer-to-peer lending, investors give personal loans to borrowers and expect an average annual return of 7% to 11%. Unlike title loans, the loans made here are unsecured. Peer-to-peer lending is basically banking without the bank. It’s making loans and returning the proceeds to investors; but in peer-to-peer lending, the intermediary, which is the bank, is removed. However, this does not mean that the bank is totally uninvolved in the process. P2P platforms may use banks as servicing agents in administering each loan, but since the involvement of the bank is limited, charges are lower.

As an investor, you can browse through borrower profiles to decide if you want to make a loan or not. Most loans are funded by more than one investor. You will likely be investing in a series of “notes,” which represent small portions of various loans. Some denominations can go as low as $25. This is a form of diversification. It allows you to spread a relatively small investment across different loans. It also provides a cushion for when a borrower defaults, which is very likely to happen.

Speaking of which, what are the risks involved?

Before jumping onto this type of investment, know the risks first:

A large number of borrowers defaulting on their loan commitments may pose a high risk even after you’ve diversified.
You generally expect good loans to offset the losses brought about by the bad ones, but it is possible for loans to go bad enough to result in large losses.
If the peer-to-peer lending platform fails, found to be fraudulent, or be a victim of a security breach, the trust of the market would decline.
Just like in any other investment, a risk to be greatly aware of is yourself. Psychological risk is an investor’s tendency to get greedy when they should be cautious.

If you are aware of the risks involved in P2P and take an effort to learn how to mitigate them, a lending investment such as P2P can be a good addition to your investment portfolio.

This article originally appeared on Payment1.com.