Most people think they understand how interest works. You invest $100 at 10% then your annual interest payment is $10 a year. If you are investing for a fixed term, say three years, that will mean $30 in total interest payments. Simple math.
But with p2p lending it is different. This same $100 invested in a 36-month p2p loan at 10% will get you far less interest than $30. If we compare apples to apples and assume no service fees then this $100 investment will net you around $16.15 in interest, close to half the interest from the previous example. What gives?
P2P Loans Are Amortized
Are you really getting just over 5% or so annually on your money? No. The reason the total interest is less is because you are investing in a fully amortized loan. What this means is that with each payment you are being paid back some principal as well as interest.
Let’s continue our example to demonstrate. The monthly payment for your $100 loan at 10% is $3.23. Given a standard amortization schedule the first payment is split into $2.39 of principal and $0.83 of interest. So, your $100 investment has been paid down by $2.39 and the principal balance is now $97.61. S0, next month you will not receive interest on $100, you will receive interest on $97.61. Herein lies the big difference with amortized loans.
Below is the full amortization schedule for a $100 loan at 10%. Now, keep in mind I am ignoring service fees in this example – in reality at Lending Club and Prosper a 1% service fee is deducted with each payment.