Understanding the Risks of Peer-to-Peer Lending

Peer-to-peer lending is very popular these days. After all, it is an easy way for investors to earn a decent return on their money. Moreover, it enables people who might not otherwise qualify for a loan to get cash for their expenses. Peer-to-peer lending allows potential borrowers to request loans from other individuals and set the terms of these loans. Potential lenders then have the option to fund the loan or not, taking on the potential for reward that comes with lending money. Generally speaking, peer-to-peer lenders and borrowers meet through a peer-to-peer lending website.

As with any financial decision, there is some risk involved with peer-to-peer lending. Borrowers and lenders alike must be aware of the risks associated with this innovative way of obtaining financing and how they can minimize these risks.

Borrowers

You might think that borrowers do not face many risks when they choose peer-to-peer lending. It is true, of course, that their financial risks are lower than the risks lenders take on in the loan process. Nevertheless, there are dangers and hurdles that borrowers face in peer-to-peer lending.

Although borrowers with poor credit are more likely to get a peer-to-peer loan than they are to get a traditional bank loan, it is still possible that no peer-to-peer lender will want to fund your loan if you are considered a high-risk borrower. Furthermore, the larger the loan requested, the more likely it is that lenders will refuse the loan. Borrowers can reduce this risk if they request smaller amounts of money and also provide a lot of information about their financial situation to potential lenders in the loan request. Taking out several smaller peer-to-peer loans and paying them back quickly can also build up your reputation and make lenders feel better about extending a loan to you.

There is also the risk that the only loans you as a high-risk borrower might get are those that have an extraordinarily high interest rate. Again, the best way to avoid this is to demonstrate that you are not a high-risk borrower through the rapid repayment of several smaller loans.

Lenders

As those who fund the loans, lenders face the most risk in peer-to-peer lending. The most obvious risk for lenders is that borrowers will not pay the money back. With rare exceptions, there is never an absolute guarantee that the lender will get all of his or her money back when he or she makes a loan. A careful examination of any available data about the borrowers and their financial situations will help you select low-risk borrowers. Using a third-party peer-to-peer lending company or website that has some sort of vetting process for its borrowers can also help you separate those who are likely to repay their loans from those who are likely to default.

Another risk that lenders face is that the loans they decide to fund may not actually go through. Individual lenders often contribute only a portion of the funds for a peer-to-peer loan because peer-to-peer loan facilitators allow lenders to pool their resources on one loan and lower their overall lending risk. If a person wants to borrow $1,000, for example, ten different lenders may have to put in $100 each for the loan requirements to be met and the funds to be disbursed to the borrower. You might find a loan that you are interested in as a lender but that you do not want to fund in its entirety. If enough lenders do not contribute funds to the loan, it will not go through, and you will see no return on your money. On the other hand, you will not have lost anything either.

One way to help ensure that you fund only loans that will actually go through to the borrower is to make a larger contribution to the pool of funds that are being set aside for the loan. Of course, you can also decide to fund loans in their entirety yourself, but that is a riskier move.

Conclusion

All in all, peer-to-peer lending can be a great way for both lenders and borrowers to meet their respective needs. Just be aware of the risks so that you can work to minimize them when you make or receive a peer-to-peer loan.

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