Peer-to-Peer Lending Explained

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Peer-to-peer lending is a method of financing without going through a bank. Peer-to-peer lending goes by several different names, including social lending, person-to-person lending, P2P lending—but they all essentially mean the same thing: An individual or group of individuals lends money to another individual. The purpose of the loan could be anything, including college tuition, paying off high-interest credit cards or other loans—any purpose for which a traditional loan is sought out. The loan amounts vary from $1,000 up to $35,000 or more.

The benefit of this model for borrowers is a much lower interest rate—often less than ten percent. For investors, the benefit comes from the ability to base the investment on the information provided, choosing an amount with which he or she feels comfortable. Details on the benefits to borrower and investor are discussed later in this article.

Peer-to-Peer versus Microfinance

Microfinance, while similar to Peer-to-peer lending in concept, is not the same in practice. Microfinance has been around since the mid-1800s, with a focus on helping poor individuals build an independent source of revenue. While this concept is more commonly associated with developing countries, a number of organizations in the United States provide microfinance services. Usually run by non-profit organizations, the loans are generally very small, totaling less than $1,000. In addition, there are a number of criteria that need to be met, including establishing low-income and/or minority status, which may be different from the average person seeking a peer-to-peer or traditional loan.

A Short History of Online Peer-to-Peer Lending

The concept behind P2P lending is not new. Individuals have loaned money or items to other individuals since the dawn of civilization. If you’ve ever visited the “Bank of Mom and Dad,” or loaned money to a friend or relative, you have the basic concept of what peer-to-peer lending is. The modern day concept involves the Internet, which has propelled the concept of P2P lending into a whole new age.

In February 2005, the first online P2P lending institution was launched in the United Kingdom. The following year, the U.S.-based company, Prosper, opened its virtual doors to borrowers and investors. In May 2007, another company, Lending Club, joined the ranks. Each of these companies performs the same service, working as a facilitator in joining borrower and lender. Each company’s business model is based on bypassing traditional sources of borrowing money, such as banks, credit unions and finance companies.

In 2008, the Securities and Exchange Commission (SEC) approached Prosper and Lending Club with the demand that they register the loans they facilitated with the SEC as promissory notes. The companies were required to put a freeze on the infusion of new funding in order to restructure their operations to accommodate the SEC’s demands. After several months of restructuring, the companies have reemerged to operate as they previously had, but under the watchful eyes of the SEC. In addition to the registration of loans as notes, the SEC requires that all information about the companies’ finances is available to the public.

Since that time, a number of other players have entered the game, with each one required to have the same transparency. Lending Club and Prosper remain the leaders in this form of lending in the U.S.

A New Way to Borrow

Peer-to-peer lending remained popular, but the financial industry’s near-collapse in 2008 put P2P lending companies in the spotlight. Traditional banks found themselves in the hot seat for granting loans to high-risk borrowers, among a multitude of other things. The federal government bailed them out, but the crisis was in no way over. Even while the country was reeling from the damage the banking industry helped to bring about, the banks themselves could not be counted on to help the nation get back on its feet. As quickly as they recovered, the banks increased interest rates and fees where they could, and refused loans to all but those with the highest credit scores.

While this was happening, the country had already been struggling with record-high unemployment rates and the steady decline of home values. The aftermath of the bank bailout was the proverbial straw that broke the camel’s back, launching the country further into the worst recession in recent memory.

Borrowers and cardholders watched helplessly as their credit card interest skyrocketed; credit limits were slashed; and mortgage and refinance loans were summarily denied. The majority of these people had a good history with their lenders. They paid their bills on time, had good or better credit scores and did nothing to encourage such moves. This arbitrary move by the banks as a result of the bailout contributed greatly to the borrowing public’s building mistrust in any financial institution.

Enter peer-to-peer lending. For many borrowers, P2P lending has become the answer to the problem of obtaining a loan with a reasonable interest rate. For investors, it’s a way that they can help other people with their financial needs and earn a better return than many other types of investments. Below are overviews of the benefits and disadvantages of P2P lending from the perspective of both borrowers and investors.

Peer-to-Peer Lending for Borrowers

Peer-to-peer lending is an interesting blend of traditional borrowing, investing, bidding sites and social networking. While there may be slight differences, the process goes something like this:

  • Borrower joins one of the P2P provider websites and fills out the loan application. The information required is essentially the same as if borrowing from a traditional lender: the amount needed to borrow, the purpose of the loan, credit history and income information.
    Requirements for consideration:
    • U.S. citizen
    • Age 18 or older
    • Have a valid checking account
    • Have social security number
  • If the application is approved, the loan request is shown on the investors’ platform, where the investors will go over the details and decide how much money, if any, to put toward the loan. Many investors put a small amount toward a number of loans, thereby diversifying their risk. A note: Investors do not have access to personally identifying information. However, the borrower’s credit report and FICO score are part of the approval process to help investors determine whether to invest in the individual loan.
  • The amount of time it will take to fund the loan varies. Generally, there is a 14-day limit. If the loan is not funded in that time, the loan request may be removed from the investors’ platform.
  • During the waiting period, investors can ask questions of the borrower, which will help them in the decision-making process.
  • If the loan is funded, the money is dispersed to the borrower, minus a reasonable origination fee.
  • If the loan is not funded completely, the loan request may be removed from the platform. However, if the funding reaches a certain threshold of percentage to the total amount, the borrower may be offered the option to accept the lesser amount or withdraw the loan request.
  • Payment schedule for the loan varies, but ranges between one and five years. Check with the P2P provider to determine loan duration choices.

Suggestions for the New Borrower

Low credit scores may be allowed. Peer-to-peer providers require a minimum FICO score to gain a loan. If the borrower’s score is above 600, he or she may find a provider willing to help. However, borrowers should understand that the lower the FICO score, the higher the interest rate. The highest interest rates can exceed 30 percent, which may not be feasible for the borrower.

Full disclosure is encouraged. The borrower doesn’t need to go into the details of Fluffy’s surgery or other non-essential intricacies of the reason the money is needed. However, some P2P providers offer an open dialogue between borrower and investor, which can help the borrower further explain their need or circumstance.

Pay on time, every time. With P2P lending, the borrower is dealing with a group of individual investors, not a faceless bank. All the people who fund a borrower’s loan generally are not finance fat cats, but regular everyday people who want to help.

Pros and Cons for Borrowers

There are distinct advantages to the borrower. A lower interest rate for most borrowers is a reality. The lack of an intermediary, such as a bank, contributes greatly to the lower interest rate. If there are questions about credit issues or income, the borrower has the opportunity to explain his or her unique circumstances to the investor(s) directly, so the borrower has a better chance of obtaining a loan than from a faceless bank.

There is no prepayment penalty if the borrower wishes to pay off the loan before the end of the term. There are no hidden fees. The only other fee a borrower may encounter is a late fee if the payment is not made within 15 days past the due date.

As with all loans, the borrower’s credit score contributes to the interest rate. The P2P provider will assign the application a grade based on the borrower’s credit score and other factors. The higher the risk is to the investor, the higher the interest rate will be for the borrower.

The borrower pays an origination or closing fee after his or her loan is funded, which depends on the overall grade of the loan. The fees may be less than one percent, up to five percent. This amount is taken off the loan amount, so borrowers should request slightly more than they need.

Peer-to-Peer Lending for Investors

The investor side of the equation is different but no less detailed than for the borrower. Each P2P provider has certain requirements for investors, as well as plenty of restrictions, depending on location. Check with the P2P provider to determine what regulations and restrictions apply in your case. Generally, investors must meet the following criteria:

  • Investors from certain states are not allowed to participate, due to state-level regulations.
  • Investors must show a minimum net worth, a minimum income or a combination of the two. Income and net worth restrictions may be different in certain states, even when participation is allowed.

Suggestions for the New Investor

Peer-to-peer lending can be a bit daunting at first, if the investor isn’t used to direct interaction with the recipient of his or her investment. This is a crucial part of the P2P model, and it may take some getting used to it. Some advice to help get started:

Choose your system. Depending on the P2P provider, you may be able to choose between an automated plan, where funds are dispersed automatically, according to the investor’s preset criteria or to invest in loans on an individual basis. Investors report that the returns on individual loans are generally higher than the automated programs. Check with the P2P provider for more information.

Use the filters provided. Each P2P system offers a set of filters that enables the investor to select only the criteria he or she wishes to see. This will streamline the process of locating only borrowers that the investor wishes to fund, without having to evaluate all available borrowers.

Start slowly and small. If the investor has decided that he or she wants to invest $5,000, and you have 20 borrowers chosen, don’t start out with investing $250 into each one. Start with $100, $50 or even $25 at first. Wait a week or two, and then check out more borrowers in which to invest.

Choose wisely. Thoroughly read the details provided for each borrower. Don’t be afraid to ask questions. A borrower with a high credit score might not have as high a return as a borrower with a low credit score, but be mindful that the borrowers with the lowest credit scores also have the highest default rates. Spreading your investment around evenly between high and low risk borrowers is just like diversifying between the stock market and government bonds.

Pros and Cons for Investors

Investing in peer-to-peer lending can be a very rewarding experience. The investor can interact with the borrower during the funding process, which can provide the investor with insight into the character of the borrower.

The ability to diversify even a large amount into very tiny portions can provide an advantage when it comes to risk management. As with high and low risk investments, there will be high and low risk loans, each with an inverse proportion of potential profit. Spreading money around lowers the overall risk, and increases the potential returns.

The Future of Peer-to-Peer Lending

As the economy slowly heals from the damage of the backlash of the recession and resultant issues brought on by shady lending practices, more borrowers will turn toward P2P lending as a way to avoid the high-interest credit cards and other loans that present a hurdle to getting themselves out of debt. Lower interest loans, such as those provided by P2P lenders, are what many experts recommend to assist people in getting on the path to financial well-being. Investors will find P2P systems as a hands-on method of determining exactly where their money is going, as well as gaining satisfaction in the knowledge that they are helping in the recovery of the country’s economy.