Understanding How P2P Lending Works

January 05, 2018 · 5 minute read

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Understanding How P2P Lending Works

Sometimes you need a loan for a venture that a traditional bank might not approve: A travel loan so you can voyage to Antarctica before settling into an all-consuming career, or a small business loan for a startup you’ve poured your heart and soul into. Or maybe it’s just time to consolidate some of the credit card debt that crept up when you weren’t looking.

A peer-to-peer (P2P) loan might be what you’re looking for. P2P 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 individual investors couldn’t earn the returns they had in the past from cash sitting in savings accounts or CDs.

Enter P2P lending sites. A few companies noticed the untapped market and developed online platforms where potential borrowers and investors could find each other. P2P lenders essentially cut out the middleman (banks and traditional lenders) and created a space for borrowers and investors to do business. Since many people are increasingly skeptical of big banks, especially following the recession, the concept of lending person-to-person took off.

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

What is P2P lending?

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

Most of the personal loans offered on P2P platforms range from $1,000 to $40,000 and have repayment periods of approximately 36 months. Interest rates can vary widely, from around 6% to 36%, depending on many factors which may include what the loan is for, credit history, and risk.

The lending platforms make money from being the intermediary in this process. In exchange for keeping records and transferring funds between parties, they charge a fee—typically a 1% annual fee from the investors lending the money. Some also charge origination or closing fees to the borrowers, which typically range from 1% to 5% of the loan amount.

In addition to personal loans, many P2P platforms may also offer small business, medical, and education loans as well.

How does 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. (Many lenders have pretty strict criteria for credit history, because they want to make sure you can pay back what you borrow.) 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 most 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 interest rates 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.

Pros and Cons of P2P lending

Pros for borrowers:

The biggest advantage for a borrower is being eligible for a loan that might not have been offered by a traditional lender. Also, P2P lenders might approve your loan faster and offer a more competitive rate than a traditional lender would.

One way people are using P2P loans is to crush their credit card debt. People with high credit card balances could be paying up to 20% 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. Similarly, 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 for investors:

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.

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

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 be help give their borrowers’ a happy ending to those stories.

Problems with P2P lending

The biggest disadvantage of P2P lending is risk—for both the investors and the borrowers. 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. (Though for some investors, that’s part of the fun.)

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 to borrowing rather than accept a loan that costs too much.

Plus, 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 info might feel like too much for some borrowers.

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 of the lending platforms may have hit serious growing pains as well: Lending Club almost collapsed in 2016 when the former CEO made headlines for selling $22 million in loans under false credentials. As regulations around the industry change and an improving economy tempts investors elsewhere, the concept could lose steam, putting the lending platforms in danger of closing.

A P2P loan vs. a personal loan

Shopping around for both a P2P loan and a personal loan is the best way to figure out which is the best match for you. Factors like your credit history, the loan amount, and what it’s for may determine whether you’ll qualify for better rates from a bank or a P2P lender.

Try using one of the many websites that help you compare rates and terms for personal loans. When comparing interest rates, don’t forget to factor in any additional origination and closing fees associated with each loan. Most of all—read the fine print on any loan you’re taking on.

Check out SoFi personal loans today to learn more!


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