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Understanding How P2P Lending Works

By Becca Stanek. June 12, 2024 · 10 minute read

THIS ARTICLE MAY INCLUDE INFORMATION ABOUT PRODUCTS, FEATURES AND/OR SERVICES THAT SOFI DOES NOT PROVIDE. SOFI LEARN STRIVES TO BE AN EDUCATIONAL RESOURCE AS YOU NAVIGATE YOUR FINANCIAL JOURNEY. WE DEVELOP CONTENT THAT COVERS A VARIETY OF FINANCIAL TOPICS WITH THE AIM TO BREAK DOWN COMPLICATED CONCEPTS, KEEP YOU INFORMED ON THE LATEST TRENDS, AND CLUED-IN ON THE STUFF YOU CAN USE TO HELP GET YOUR MONEY RIGHT.

Understanding How P2P Lending Works

Sometimes you need a loan for a venture that a traditional bank might not approve. In these instances, a peer-to-peer (P2P) loan might be what you’re looking for. Peer-to-peer lending, also known as social lending, rose out of the 2008 financial crisis. When banks stopped lending money as freely as they had in the past, potential borrowers had fewer loan options. At the same time, low interest rates meant lower returns from savings accounts or CDs.

Enter P2P lending sites. P2P lenders essentially cut out the middleman (banks and traditional lenders) and created a space for borrowers and investors to do business. Since then, the concept of lending person-to-person has taken off, with the rise of a number of peer-to-peer lending platforms.

Wondering if a P2P loan is right for you? Or if investing in P2P lending is a smart way to diversify your portfolio? Let’s take a look at some of the pros and cons.

Key Points

•   Peer-to-peer (P2P) lending connects borrowers directly with investors, bypassing traditional banks, and emerged after the 2008 financial crisis when lending options diminished.

•   The most common P2P loans are personal loans, with amounts ranging from $1,000 to $50,000, typically having repayment periods of 36 to 60 months.

•   Investors face risks, including the possibility of borrower defaults, as P2P loans are unsecured and not FDIC-insured, making returns uncertain.

•   P2P lending offers benefits such as easier eligibility and competitive rates for borrowers, while providing investors with potential higher returns and a sense of community.

•   Despite its advantages, P2P lending involves risks for both parties, including higher interest rates for borrowers and uncertainties regarding the industry’s regulation and stability.

What Is Peer-to-Peer (P2P) Lending?

P2P lending links up people who want to borrow money with individual investors who want to lend money. P2P lending sites like Prosper, Upstart, and Kiva — three prominent P2P lenders — provide low-cost platforms where borrowers can request loans and investors can bid on them.

The most common type of loan available through P2P lending is a personal loan, which provides borrowers with a lump sum of money they can use for virtually any purpose. However, other types of loans, including car loans, business loans, and home loans, are offered.

Personal loan amounts offered on P2P platforms range anywhere from $1,000 to $50,000 and repayment periods are typically 36 to 60 months. Interest rates can vary widely, from around 7.5% to 35.99%, depending on factors including the individual’s credit history and perceived risk, as well as the purpose of a loan.

The lending platforms make money from serving as the intermediary in this process. In exchange for keeping records and transferring funds between parties, they charge a fee — typically 0.5% to 1.5% of the interest earned — to the investors lending the money. Some platforms also charge origination or closing fees to the borrowers, which typically range from 1% to 8% of the loan amount.

Is Peer-to-Peer Lending Safe?

The bulk of the risk of peer-to-peer lending falls onto investors. It’s possible that borrowers will default on their loans, and that risk increases if the investor opts to lend to those with lower credit ratings. If the loan were to go into default, the investor may not get paid back.

Further, peer-to-peer lending is an investment opportunity, and returns are never guaranteed when investing. There is the risk that investors could lose some or all of the amount they invest. Unlike deposit accounts with a traditional bank or credit union, P2P investments are not FDIC-insured.

How Does Peer-to-Peer (P2P) Lending Work?

The basic P2P lending process works like this: A borrower first goes through a quick soft credit pull with the P2P lending platform of their choice to determine initial eligibility. If eligible to continue, the lender likely will conduct a hard credit pull and then assign a borrower a “loan grade,” which will help lenders or investors assess how much of a risk lending to them might be.

The borrower can then make a listing for their loan, including the interest rate they’re willing to pay. With some P2P lending platforms, the borrower has an opportunity to make a case for themselves; they can provide an introduction and describe why they need the loan. A compelling, creative listing might have more luck grabbing a lender’s attention and trust.

Next, lenders can bid on the listing with the amount they can lend and the interest rate they’d be willing to offer. After the listing has ended, the qualified bids are combined into a single loan and that amount is deposited into the borrower’s bank account.

Peer-to-Peer (P2P) Lending Examples

Here are some examples of popular peer-to-peer lending sites:

•   Prosper: Prosper can provide loans in amounts anywhere from $2,000 up to $50,000. Loan terms are two to five years, and funding can happen in as little as one business day.

•   Upstart: Upstart is an AI lending marketplace that can offer borrowers loans of up to $50,000, with loan terms of either three or five years. It’s possible to check your rate in minutes, and most loans are funded within one business day after signing.

•   Kiva: Kiva connects borrowers in need of money to fund their small businesses with a network of lenders who aren’t seeking to make a profit. Kiva requires borrowers to get some funding from one of the microlending partners. Once a certain threshold amount is met, their loan becomes available for public funding.

Peer-to-Peer (P2P) Lending for Bad Credit

It is possible to get a peer-to-peer loan with a bad credit score (meaning a FICO score below 580). However, those with lower credit scores will almost certainly pay higher interest rates.

Additionally, those with bad credit may have more limited options in lenders, though there are peer-to-peer lending platforms for bad credit. Many platforms have minimum credit score requirements, which tend to be in the range of fair (580-669) to good (670-739). For instance, Prosper requires a minimum score of 600.

If you have bad credit and are seeking a P2P loan, you might first work to improve your credit profile before applying. Or, you could consider getting a cosigner, which can increase your odds of getting approved and securing a better rate if you’re finding it hard to get a personal loan.

Peer-to-Peer (P2P) Lenders Fees

Peer-to-peer lending platforms can charge fees to both borrowers and investors. Which fees apply and the amount of these fees can vary from lender to lender.

A common fee that borrowers may encounter is an origination fee, which is typically a percentage of the loan amount. Other fees that borrowers may face include late fees, returned payment fees, and fees for requesting paper copies of records.

Investors, meanwhile, may owe an investor service fee. This is generally a percentage of the amount of loan payments they receive.

Recommended: Fee or No Fee? How to Figure Out Which Loan Option Saves You the Most

Pros of Peer-to-Peer (P2P) Lending

There are upsides to peer-to-peer lending for both borrowers and investors. However, the benefits will differ for both parties involved.

Pros of P2P Loans for Borrowers

•   Easier eligibility: The biggest advantage for a borrower getting a personal loan peer-to-peer is being eligible for a loan they might not have been able to get from a traditional lender.

•   Faster approval and competitive rates: P2P lenders might approve your loan faster and offer a more competitive rate than a traditional lender would.

•   Possible to pay off credit card debt: One way that people are using P2P loans is to crush their credit card debt. People with high credit card balances could be paying up to 24.37% APR or higher in interest charges. If they can wipe it out with a P2P loan at a lower interest rate, it can save them a lot of money.

•   Option to finance upcoming expenses: Those who are facing a lot of upcoming expenses might find it more cost-effective to take out a P2P loan rather than put those expenses on a high-interest credit card.

Pros of P2P Loans for Investors

•   Promising alternative investment opportunity: Some see P2P lending as a promising alternative investment. When you lend money P2P, you can earn income on the returns as the borrower repays you. Those interest rates can be a few percentage points higher than what you might earn by keeping your money in a savings account or a CD. While there is some risk involved, some investors see it as less volatile than investing in the stock market.

•   Option to spread out risk: P2P lenders also offer many options in terms of the types of risk investors want to take on. Additionally, there are ways you can spread the amount you’re lending over multiple loans with different risk levels.

•   Sense of community: For borrowers and investors, the sense of community on these sites is a welcome alternative to other forms of lending and investing. Borrowers can tell their stories and investors can help give their borrowers a happy ending to those stories.

Cons of Peer-to-Peer (P2P) Lending

Though there are upsides to peer-to-peer lending, there are certainly drawbacks as well. These include:

•   Risk for investors: The biggest disadvantage of P2P lending is risk. Since P2P loans are unsecured, there’s no guarantee an investor will get their money back. The borrowers on a P2P site might be there because traditional banks already declined their application. This means investors might need to do extra legwork on their end to evaluate how much risk they can take on.

•   Potentially higher rates for borrowers: While P2P lenders might approve a loan that a traditional bank wouldn’t, they might offer it with a much higher interest rate. In these cases, it could be wiser to search for alternatives rather than accepting a loan with a costly interest rate.

•   Effort and personal exposure for borrowers: There can be a lot of effort and personal exposure involved for the borrower. Borrowers have to make their case, and their financial story and risk grade will be posted for all to see. While we’re used to sharing a lot of our lives online, sharing financial information might feel like too much for some borrowers.

•   Relatively new industry with evolving regulations: Then there’s the risk of P2P lending itself. The concept is still relatively new, and the decision on how best to regulate and report on the industry is still very much a work in progress. Some lending platforms have already hit growing pains as well. As regulations around the industry change and investors are tempted elsewhere, the concept could lose steam, putting lending platforms in danger of closing.

Recommended: 11 Types of Personal Loans & Their Differences

Peer-to-Peer (P2P) Loans vs Bank Loans

When it comes to P2P loans compared to bank loans, the biggest difference is who is funding the loan. Whereas bank loans are funded by financial institutions, peer-to-peer loans are funded by individuals or groups of individuals.

Further, bank loans tend to have more stringent qualification requirements in comparison to P2P loans. This is why those with lower credit scores or thinner credit histories may turn to peer-to-peer lending after being denied by traditional lenders. In turn, default rates also tend to be higher with peer-to-peer lending.

The Takeaway

Peer-to-peer lending takes out the middleman, allowing borrowers and investors to do business. For borrowers, P2P loans can offer an opportunity to secure financing they may be struggling to access through traditional lenders. And for investors, P2P loans can offer an investing opportunity and a sense of community, as they’ll see where their money is going. However, there are drawbacks to consider before getting a peer-to-peer loan, namely the risk involved for investors.

Whether you’re getting a P2P loan or a loan from a traditional lender, it’s important to shop around to find the most competitive terms available to you.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.

SoFi’s Personal Loan was named NerdWallet’s 2024 winner for Best Personal Loan overall.

FAQ

Is peer-to-peer lending safe?

There are certainly risks involved in peer-to-peer lending, particularly for investors. For one, borrowers could default on their loan, resulting in investors losing their money. Additionally, there’s no guarantee of returns when investing.

What is peer-to-peer lending?

Peer-to-peer lending is a type of lending wherein individual investors loan money directly to individual borrowers, effectively cutting out banks or other traditional financial institutions as the middlemen. This can allow borrowers who may have been denied by more traditional lenders to access funds, and provide investors with a shot at earning returns.

What is an example of peer-to-peer lending?

Some popular P2P lending sites include Prosper, Upstart, and Kiva. Borrowers can use peer-to-peer loans for a variety of purposes, such as home improvement, debt consolidation, small business costs, and major expenses like medical bills or car repairs.


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