Peer-to-peer lending, or P2P lending for short, is a way for borrowers to get loans from other individuals, rather than a bank or other traditional lending institution. It’s often used by borrowers who either are unable to qualify for a traditional bank loan or cannot secure the type of financing they’re looking for.
Due to the type of borrowers typically seeking P2P loans, this type of financing tends to have higher default rates than traditional loans. Despite this increased level of risk, many P2P lenders choose to engage in lending activities because it has the potential to yield greater returns in the form of higher interest rates.
How Peer-to-Peer Lending Works
Although P2P lending is made possible by individual investors willing to lend their own money, individual companies run and host websites that match borrowers to lenders. Various P2P lending websites exist, each with various fee structures, niche programs, and lending processes.
Below, I’ll go through what borrowers and lenders typically experience as part of the P2P lending process.
Borrowers
Borrowers seeking a loan via peer-to-peer lending will typically go through the following steps:
Peer-to-peer lending platforms have varying fee structures and loan types that can be offered. This can include personal loans, working capital loans, business loans, auto loans, medical loans, and student loans. P2P platforms also have varying qualification requirements and levels of expertise when it comes to lending to certain industries or business types.
The borrower must submit a formal loan application; doing so may result in a hard pull of the applicant’s credit report. As part of the application process, the borrower’s qualifications will also be reviewed, and paperwork may be requested to verify eligibility. This can include bank statements and proof of income.
When eligibility is confirmed, the borrower can then select a loan based on the specific terms being offered. Loan offers may vary by funding amount, repayment term, and interest rate.
After signing the loan agreement, borrowers should verify receipt of funds via the payment method they’ve designated. This is commonly a business checking account. Once loan proceeds have been disbursed, the borrower must then make repayments as stated in the loan agreement.
Lenders (Individual Investors)
Individual investors looking to lend their funds to prospective borrowers will generally go through these steps:
Similar to how borrowers shop different platforms, investors too should consider different P2P websites to find one suited to their preferences. Platforms have differences in the fees they charge, the number and type of borrowers seeking funding, and the repayment rates of loans issued.
As part of the registration process, investors may be asked to indicate the characteristics of a borrower they’d be willing to issue funding for. This can include specifying minimum interest rates, credit scores, business type, industry, funding amount, repayment term, and more. Funds must also typically be transferred from the investor to the P2P platform, as loans will be issued from those proceeds.
Depending on how the peer-to-peer lending platform is set up, investors can review loan requests and choose which ones they’d like to fund. Options may also be available to fully or partially fund a borrower’s funding request.
Once a loan has been issued, investors can monitor the repayment of the loan through the P2P platform’s user dashboard. Depending on how the loan has been structured, investors may receive repayment on an ongoing basis, although some may not receive funds until the loan has been fully repaid. Note that P2P platforms do charge fees, which are typically deducted from each payment.
Pros & Cons of P2P Lending
Peer-to-peer lending carries a different set of highlights and drawbacks depending on whether you’re using it to borrow or lend funds. To help you identify who it’s for, I’ve outlined the benefits and downsides for borrowers and investors below:
Pros & Cons for Borrowers
| Pros | Cons |
|---|---|
| Has more flexible eligibility criteria for funding: It bypasses the need to meet a bank’s requirements, so individual investors/lenders have more flexibility in determining minimum eligibility criteria for borrowers. | Tends to have higher rates and fees: Since eligibility criteria are more flexible than most bank loans, the statistical likelihood of a loan default goes up. As a result, rates and fees tend to be higher to reflect the added level of risk. |
| Can have fast approval and funding times: P2P platforms often use some form of automated system to identify eligibility based on a borrower’s credit profile. This significantly reduces the time needed to manually review certain aspects of a loan application. | Has loan support that’s not as robust as banks: Loan support tends to be less robust than a traditional bank or lender. One example of this is a reduced ability to ask for payment deferrals or modifications to loan terms if you are struggling to afford the monthly payments. |
| Tends to have fewer paperwork requirements: P2P loans can be bound by fewer regulations than banks. As such, the level of due diligence needed before a loan approval is issued is sometimes greatly reduced, which can include the amount of paperwork required to document eligibility. | May not be available in all areas: Lending regulations in certain states may prohibit P2P lending from being offered. |
Pros & Cons for Investors/Lenders
| Pros | Cons |
|---|---|
| Can provide high rate of returns: Compared with traditional loans, P2P lending is higher risk, but the tradeoff is that investors and lenders can charge higher rates, and potentially earn greater returns on the amount lent out. | Has payment structures that may vary: P2P loans and platforms are not all created equal. Some may only provide payment once the original loan has been paid in full, as opposed to providing payments on an ongoing basis as borrowers make loan payments. |
| Makes it easy to get started as an investor: The capital requirements to get started as an investor are generally low. Some platforms allow investors to get started with as little as $25. | Lacks protection against loan defaults: P2P loans are rarely secured by any type of collateral. As a result, investors will have little to no recourse if a borrower defaults on a loan. |
| Offers the ability to generate regular monthly income: Many P2P loans require monthly repayments. As borrowers make payments, they can be regularly deposited to the investor’s account, providing a recurring source of passive income. | May have instability due to changing regulations: It is relatively new, compared with traditional loans, and as such, it can be more susceptible to regulatory changes that can limit the profitability and availability of this type of lending. |
P2P Lending: Rates, Terms & Qualifications
Peer-to-peer lending tends to have more flexible eligibility criteria, so it’s often sought by borrowers who are unable to get a small business loan through banks due to bad credit or poor business finances. A big tradeoff for borrowers, however, is that rates and terms tend to be less competitive.
While exact figures will vary depending on the P2P platform you choose, below are typical figures you are likely to see:
How to Choose a P2P Platform
Regardless of whether you intend on using peer-to-per lending as a borrower or investor, I suggest considering the following characteristics when selecting a P2P website:
- Rates and fees charged
- Historical default rates
- Industry specializations
- Loan terms (such as loan amount, repayment terms, and repayment schedule)
- Funding speed
- Geographic availability
Frequently Asked Questions (FAQs)
Minimum credit score requirements typically range from 600 to 650. However, this depends on the P2P platform being utilized, the type of financing terms you’re looking for, and any other compensating factors you may have, such as strong income or assets.
Peer-to-peer lending allows individual investors to lend funds to other individuals. It’s often used by borrowers who are unable to get approved for financing through traditional banks. Qualification requirements tend to be more flexible for P2P lending, but it typically comes at the cost of higher rates and fees.
It’s not unusual for investors to see a return on investment (ROI) of 10% or greater. However, returns are never guaranteed and can depend on things like the number and type of borrowers in the investor’s portfolio and the investor’s willingness to lend to high-risk borrowers.
Bottom Line
P2P lending is a way for borrowers to get funding from other individuals rather than from a bank. For borrowers, this can allow funding to be issued if they are unable to meet a bank’s lending requirements. From an investor standpoint, they can get higher rates of return due to the higher interest rates that are often charged for these types of loans. Before selecting a website to use for peer-to-peer lending, see how it compares with at least several other P2P platforms as each has varying fee structures and loan programs.
