May 11, 2022

What is peer-to-peer (P2P) lending?

The loan between individuals is a loan that is generally done online between two people. Instead of going to a bank, the borrower uses an online marketplace to locate a lender quickly and often with less paperwork.

Peer-to-peer lending began as an unsecured (i.e. without collateral) personal lending industry. It has evolved to include business loans, secured loans and other niche types. Let’s review what you need to know.

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Peer-to-peer loan defined

Peer-to-peer (P2P) lending is lending that is often done through an online marketplace. The borrower and the lender are often individuals who are matched by an algorithm.

Unlike traditional loans made through banks or credit unions, P2P loans eliminate much of the paperwork, credit scoring, and general hassle. In exchange for this convenience, borrowers often pay higher fees.

How does the loan between individuals work?

Let’s take a look at how loans often work for both a borrower and a lender.

P2P loan for a borrower

The good news for borrowers is that P2P loans are much more flexible than traditional loans. When a bank or credit union has to follow thousands of regulations and withstand multiple audits each year, your P2P lender might be your boss, a neighbor, or some random student who just inherited the money. These lenders may be more open to lending based on a sophisticated fintech algorithm instead of traditional metrics like debt-to-income ratios and credit scores.

Most P2P marketplaces have a bare minimum of credit standards that you must meet. For example, Reached (NASDAQ: UPST) requires a credit score over 560, no bankruptcy in the past 12 months, no currently delinquent accounts, and less than six inquiries into your credit in the past six months. This level of screening weeds out potential borrowers who the market believes are not worth the potential return. After this initial selection, many marketplaces allow borrowers and lenders to connect.

Additionally, P2P marketplaces are often more open about the reason for rejection. Banks and other financial institutions sometimes have to be discreet about declines to avoid legal problems.

As a borrower, all you need to do is fill out an application on the marketplace website to determine the type of loan, interest rate, and loan amount you may be eligible for. Then you choose whether or not to accept the loan. Once you accept the loan, you set up an ACH (Automated Clearing House) payment, sign the loan documents, and pledge any collateral you use to secure the loan.

Loan origination is when you will pay the loan fees. P2P lending fees are notoriously high (sometimes up to 8%) compared to traditional bank fees, which typically hover around 1% for personal loans. High fees are how the market makes money. Be sure to do the math and make sure you get a lower interest rate to offset the increased fees.

P2P loan for a lender

P2P loans can be an attractive investment for individual investors. The bond market is so saturated and rates are so low that it’s rare to find an investment yielding more than 5% unless it’s extremely risky.

Of course, P2P borrowers generally come with high levels of risk. They often use P2P lending because they cannot qualify with a traditional bank. We will discuss risk in more detail below.

P2P lenders find a market they like, deposit the money to invest, and start lending. Usually, the market will ask you to complete your own application detailing the level of risk you are willing to take and the types of loans you prefer to make.

From there, you log in, view available loans, and choose whether or not to invest. Some markets will rank loans based on risk, but all should give you some level of information about the borrower. Some marketplaces also allow you to invest in a pool of similar loans.

How safe are peer-to-peer (P2P) loans?

Credit risk is the key factor for P2P lenders. As noted earlier, many P2P borrowers could not qualify for a traditional bank loan and are turning to P2P loans as an alternative. That said, traditional banks aren’t necessarily good at determining an individual’s credit quality.

Bank lending standards have remained virtually the same over the past 50 years. The underwriter verifies debt and income, assesses collateral, reviews credit rating and credit history, and then often makes a subjective decision.

Financial technology (fintech) companies are exploring alternative credit scores, scoring loans based on unconventional criteria, and being more flexible with interest rate ranges to match credit risk.

Despite all this, there will always be P2P loan defaults. Almost all types of loan products carry credit risk and have to deal with defaults. The best way to mitigate risk in this type of fintech is through diversification. If you invest $50,000 in P2P loans, it’s better to spread it out over 10 borrowers who need $5,000 than to spend it all on one borrower. That way, if one is lacking, you’ll still make money on the others.

Advantages and disadvantages of P2P loans

Let’s look at the pros and cons from a lender’s and borrower’s perspective:

Borrower

Benefits:

  • Interest rate: P2P lenders don’t have the huge operating expense infrastructure that many traditional banks have, so they don’t have to charge high interest rates to cover overhead. However, some P2P markets will determine interest rates based on risk, so borrowers with baggage will have to pay higher rates.
  • Flexibility: Traditional banks have to put everything in a bucket. It is either a car loan, a home equity line of credit, a credit card account, etc. P2P lenders can be more flexible with loan proceeds, loan amount, credit quality, and even speed of approval and access. take the money.

The inconvenients:

  • Costs: Marketplaces make their money on fees. Many have a sliding scale, but they’re still generally higher than what you’d pay at a bank. Of course, many borrowers are happy to pay these fees in exchange for convenience, lower interest rates, or even approval.
  • Overstretch: While traditional bank debt and income standards may seem outdated, they exist for a reason. If you qualify for a P2P loan that pushes your debt ratio to an unsustainable level, it’s not worth it.

Lender

Benefits:

  • Higher yields: P2P lending can allow individuals to build diversified personal loan portfolios at higher interest rates than they otherwise could.
  • Impact: When you buy a bond or a stock, you do so alongside many other people. When you make a P2P loan, you could be the reason a couple can afford infertility treatments or someone can buy their first home or pursue an expensive medical procedure.

The inconvenients

  • Credit risk: P2P borrowers are often not qualified for traditional loans and may have income or existing debt issues that cause them to default on their loans.
  • Lack of choice: If you choose a smaller market or have very high standards, you may face a dearth of potential investment options.

What you can use a P2P loan for

P2P loan funds can be used for various purposes. Some marketplaces will require disclosure of the use of funds in the application and then track their use to ensure the loan was used correctly. Here are some common uses:

  • Debt Consolidation
  • Education
  • Immovable
  • Medical fees
  • Business loans
  • Miscellaneous major expenses

Where to get a P2P loan

Your best bet for finding a good deal for a P2P loan is to start with a website that reviews your personal loan options. Each website caters to different types of borrowers, so this method is the best way to find the right one for you.

Pick a few and head to their websites where you can then decide which one has the easiest process, as well as the best interest rate and fee structure.