Looking for an alternative way to borrow or invest money?
Peer to peer lending (P2P) might be the game-changer you’re seeking.
By cutting out traditional financial institutions like banks and credit unions, P2P lending connects borrowers directly with individual investors.
This form of “social lending” is gaining momentum, especially with the rise of fintech platforms that make the process simple and accessible.
Whether you’re a borrower in search of better rates or an investor looking for higher returns, peer-to-peer lending opens up new possibilities—though not without some risks.
Let’s dive into how it works and what to consider before jumping in!
In this article, we will go over:
- What peer to peer lending is
- How it works
- Why people use it
- Safety concerns
- Pros and cons
What is peer to peer lending?
Peer to peer lending (P2P) is a form of direct lending.
It enables individuals to borrow money from willing individual lenders, cutting out the intermediaries. P2P lending is also known as “social lending”.
The concept of peer to peer lending is fairly young. It’s a specific form of lending that is facilitated by modern financial technology. Most of these services are offered by P2P lending websites.
There are two parties to most traditional loans:
- The borrower, who needs money now and is willing to pay back what they borrow with interest
- The lender, who seeks to profit by filling in the demand for borrowing
P2P lending is much the same, except it is between two individuals or businesses, not one individual or business and one:
- Bank
- Credit union
- Alternative lender
How it works: Peer to peer lending example
The Investor (Lender)
An investor (The person putting up the money to be borrowed.) opens a new account on a P2P lending website.
They deposit the money they want to use as their investment.
They agree to have that sum dispersed as loans to borrowers on the same site.
The Applicant/Borrower
A loan applicant also opens a new account on the P2P lending site. (Forbes.com recommends Upstart, Prosper and Lending Club.)
As with traditional lending, they have a risk profile. A risk profile is based on factors such as credit score, debt-to-income ratio, and other traditional credit risk assessment factors.
The Process
Now, both users are on the same site. The site’s entire purpose is to connect the two parties, and it also sets the rates and terms acceptable for transactions.
The borrower looks through all the offers on the site.
They can review as many applicable offers as they like. Or, sometimes, the borrower breaks up their search into multiple chunks, accepting multiple offers for the same sum.
In this case, our borrower finds the right investor and borrows from them.
The peer to peer lending platform connects these two individuals.
Once the loan is agreed upon, the P2P lending site handles the money transfer.
Then, all the repayments are also facilitated through the site. Depending on the site and circumstances, the repayment process may be completely automated.
Sometimes, the investor (lender) and the borrower will negotiate before coming to an agreement.
The borrower repays the lender-investor according to the terms they agreed upon. Ideally, both parties are satisfied.
Why do people take peer to peer loans?
Imagine you want to invest your money into a (relatively safe) debt instrument.
As an individual, you can lend money to a bank, which in turn lends that money to borrowers at a higher interest rate. Some of these individuals want a higher rate of return than they would get from most savings accounts or certificates of deposit.
Similarly, borrowers can seek loans from alternatives to traditional lenders, such as banks. They may be seeking a lower interest rate, for example.
Is peer to peer lending (P2P) safe?
Overall, peer to peer lending is less safe than other forms of lending.
Peer to peer lending includes many of the same risks as traditional loans.
Any lenders using a P2P platform have to consider credit risk (the possibility that the borrower will default on the loan or otherwise fail to meet their obligations).
This is similar to the risk banks assess and accept, as not all their borrowers can/will fulfill the contract’s obligations.
However, it should be noted that P2P lending platforms have higher default rates.
Specifics vary by location, platform, and other factors.
One of the most extreme examples is China, where P2P lending platforms had such a horrifying default rate of 87.2% in 2019, that all P2P platforms were closed in 2021.
In the US, research on public information on one of the more popular P2P sites, Lending Club, showed that while default rates dropped over 5% from Q3 2018 to Q2 2019, they were still sitting at 14.55%.
Peer to peer advantages and disadvantages
Advantages
- Can be used to consolidate other debts
- It’s possible to find competitive interest rates
- Different fee structure
- Relatively low bar of entry
- Can be used to diversify investment portfolios
- Consistent returns
- Choice in level of risk
Disadvantages
- Higher risk of delinquency or default
- Reliance on the fintech platform
- Lack of liquidity
- Possibly worse fee structure, depending on the platform
Conclusions
P2P lending started in 2005 and has since become more popular. Many investors use it as a small portion of their portfolios. The idea is simple; using technology to connect two parties.
While P2P lending has some advantages, there are some significant risks too. To avoid loss, it’s important for users to carefully vet both the platform and the borrower.
Editor’s note: This article was originally published Aug 17, 2022 and has been updated to improve reader experience.
