What is peer-to-peer lending and when should you consider it?

Peer-to-peer lending can be the answer to all kinds of situations where you need to get your hands on some cash. Maybe you want to reduce or consolidate debt, buy a car, start a small business, pay for a wedding, or replace a washing machine that just broke.

Maybe your friends and relatives can’t lend you money or you’re worried that banks will turn down your loan application. If you want to avoid accumulating credit card debt, peer-to-peer (P2P) lending might be the solution for you.

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On the other side of the equation, P2P lending can be a great opportunity if you’re looking for an innovative way to invest your money. As an investor in P2P lending, you can earn passive income while diversifying your investments and potentially reducing your overall risk. Read on for more explanation of P2P lending and when it might be right for you.

What is P2P lending?

Peer-to-peer lending – that is, person-to-person, P2P or social lending – anonymously connects borrowers and lenders through an online platform using complex computer algorithms. Here are the basic facts about P2P lending:

Personal loan amounts generally range from $1,000 to $50,000. Higher amounts may be available for small business loans and lines of credit.
Loan terms typically range from one to five years.
Borrowers make fixed monthly payments that are automatically deducted from their verified bank accounts.

There are no physical branches in the P2P lending market, which could reduce costs for borrowers and increase returns for lenders. Lending platforms make their money by charging origination fees to borrowers and deducting the fees from loan repayments made to investors.

P2P lending started over a decade ago. Prosper was launched in 2006 as one of the pioneers of online marketplace lending. Avant and Upstart are currently the main competitors. LendingClub was a top competitor until it exited the P2P space in 2020 to become an online bank.

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Criticisms of P2P lending

Time reported that all may not be rosy in the world of P2P lending. In March 2016, the Consumer Financial Protection Bureau began accepting reviews and complaints from Prosper and Lending Club. This policy was put in place to put regulatory pressure on the P2P lending sector, which had seen an increase in delinquencies.

LendingClub ultimately had to pay $18 million to settle fees with the FTC after being sued for charging consumers hidden fees and providing inaccurate loan application approval information. The platform was ordered to return more than $10 million to more than 15,000 consumers hit by undisclosed fees. With such a major player leaving the P2P space, it was certainly a wake-up call for those considering entering the space.

Advantages and Disadvantages of P2P Lending for Borrowers

For borrowers, obtaining a small personal loan via P2P lending can be an attractive alternative to dealing with traditional banks. Investors can add P2P loans to their portfolios to diversify their investments and reduce some risks.

Whichever side of the equation you find yourself on – borrower or lender – you should carefully consider the pros and cons before diving into P2P.

Benefits of P2P lending for borrowers

This online borrowing option has many advantages over traditional credit cards or personal loans:

Quick and easy online application process
Can get approved for a loan after being declined by a bank
No impact on your credit score to check your interest rate
Lower interest rates than some traditional credit cards and financial institutions
Fixed interest rates and monthly payments with no hidden fees
You remain anonymous to your lenders and they will not contact you directly
No prepayment penalty if you decide to repay the loan before it is due
Loans are unsecured, so you don’t have to provide collateral like your car’s title
There is a social aspect because you can “watch” online as investors finance your loan up to its full amount.
You can apply for additional online loans if you manage your initial loan responsibly

Disadvantages of P2P lending for borrowers

Although P2P platforms tout many benefits on their websites, there are some drawbacks you should be aware of before committing to borrowing:

You can’t always borrow to get out of debt. Chartered Financial Analyst Joseph Hogue said the most popular form of P2P lending is the debt consolidation loan, but even this alternative financing can backfire if you don’t fix the spending problem that got you into debt. first place. “If you constantly spend more than you earn, you will never get out of the debt trap,” Hogue said. In addition to interest rates, you also have to worry about origination fees and other possible hidden costs.
High interest rates apply. If your credit is not good, you will end up with a high interest rate, which will cost you more in the long run. It might be best to wait and improve your credit before applying.
Borrowers with bad credit might be out of luck. “Credit scores below the thresholds are generally not approved. Rates for borrowers at the low end will be 25 to 35 percent,” Hogue said. That’s not much better – and might be worse – than the interest rates on credit cards for people with bad credit.
Serious consequences apply if you do not manage your P2P loans correctly. “Don’t think that just because the loans are unsecured that they don’t need to be repaid. A missed payment will affect your credit score just as badly as any other type of loan,” Hogue said. “Even worse, many P2P investors refuse to lend to someone whose payment is missed, so you risk ruining your chances of getting another loan. »

Advantages and Disadvantages of P2P Lending for Lenders

Benefits of P2P Lending for Lenders

Investors have many choices for where to invest their money: stocks, bonds, CDs, mutual funds, real estate, or businesses, to name a few. Being a P2P lender is an alternative to these more traditional choices – one that offers many attractive benefits:

Lenders can be individuals or institutions
Easily open an investment account online
The initial investment in each loan can be as low as $25 (x)
You can invest in a portfolio of hundreds or even thousands of loans
Receive monthly principal and interest payments as borrowers repay their loans
Diversify your risk across many different loans rather than making a single loan or investing only in stocks.
You can choose to reinvest the payments you receive or withdraw the funds from your P2P account
You can earn higher rates of return on your money, reaching 5-9% depending on your investments. (X)
You can choose what you invest in, from a small business project to helping someone renovate their home.

Disadvantages of P2P lending for lenders

Although supplementing investments with peer-to-peer lending can be an attractive option, investors should be aware of the potential downsides:

The risk of losing all your money always exists. If you only invest in high-risk loans with double-digit interest rates, you can easily lose all your money, just like any other investment. “Don’t chase high returns without understanding the risk that comes with it,” Hogue said. “You can invest as little as $25 in each loan, but you’ll still need about $3,750 to invest in enough loans so that a few defaults don’t destroy your overall return.”
We need to diversify. To maximize your investment, diversify by investing in the right number of loans across multiple risk categories. Hogue recommended a portfolio of between 125 and 175 loans.
P2P investing is not a get-rich-quick way. You’re stuck with the loan for the term you committed to, which can be up to five years. You cannot cut your losses and sell the loan. On the other hand, Hogue pointed out that this could be beneficial for some investors because it avoids panic selling, helps investors avoid high trading fees that come with the stock market, and makes investing in loans P2P a type of fixed income investment. .

P2P loans and other options

When should you consider P2P lending versus other options as a borrower and lender? As a borrower, you have other options, such as:

Home equity loans. You tap into your home equity to access more funds at a lower rate. However, you are taking a risk by using your home as collateral.
Traditional bank loans. You can apply for a traditional bank loan if you qualify and meet the eligibility criteria.
Credit card. Although interest rates can be exorbitant on credit cards, you have instant access to cash when you need it.

Your decision may ultimately depend on your credit score and eligibility, as these factors will greatly impact your options as a borrower.

For individual lenders, adding P2P lending to your portfolio is a way to diversify your investments and potentially reduce your overall risk. However, it’s worth noting that you have a variety of other, safer investment options, ranging from high-yield savings accounts to CDs if you’re looking for better returns. In either case, you should consider the pros and cons of P2P lending before diving into finance.

Martin Dasko contributed reporting to this article.

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This article originally appeared on GOBankingRates.com: What Is Peer-to-Peer Lending and When Should You Consider It?