Peer-to-Peer Lending: What It Is and How It Works
Merriam’s defines peer as a “one that is of equal standing with another.” You aren’t on equal standing with a bank or credit union if you want a loan, but you are on a reasonably equal standing when a peer-to-peer loan is involved. Of course, the peer lender has the money the peer borrower needs. Peer-to-peer lending differs from traditional lending, and can sometimes offer lower interest rates and Annual Percentage Rates (APRs).
What Is a Peer-to-Peer Loan?
Basically, peer-to-peer loans, or P2P, consist of personal loans from private individuals. You are not dealing with a formal financial institution. However, it’s not equivalent to getting a loan from a friend or relative. P2P loans, also known as crowd or social lending, derive from websites connecting potential borrowers with investors. Look into P2P loans for personal use, debt consolidation, or home improvement.
Here is how a typical P2P loan works. An investor has opened an account on a P2P platform and deposited a specific amount of money. A person with $5,000 in high-interest credit card debt wants a P2P lender to lend them that amount at 10 percent, opposed to the 20 percent they are currently charged. The individual provides their financial information, and is assigned a risk category. Investors make loan term offers, and the borrower accepts the loan with the best terms for their purposes.
Through a P2P lending platform, the investor provides the money and receives more interest on the loan than they could at a bank. The borrower pays off the credit card debt and pays back the new loan at a much lower rate. It’s a win-win for both sides.
Expect to pay a loan origination fee of up to 8 percent. However, you won’t pay many of the other fees usually charged by banks, such as application and processing fees and the other methods used to nickel-and-dime consumers. Loan lengths generally range between two and five years. Certain P2P platforms specialize in particular borrowers, such as those dealing with medical debt or geared toward small businesses.
Peer-to-Peer Loan Advantages
Peer-to-peer loans offer advantages for both borrower and investor. For the former, it is the possibility of better terms than they could receive from a traditional lender. For the latter, it is the ability to make more money than they could by placing their funds in a bank account, CD or other conservative investment.
Why are loan rates lower? First, P2P investors do not have the overhead costs burdening financial institutions, so they do not need to charge as much in interest. P2P loans are also much quicker than loans from traditional sources. Applications are less cumbersome, and you will find out whether your loan is approved in less time. In some instances, you may find yourself approved and provided access to funds within 24 hours, versus weeks for a bank.
Borrowers with less than stellar credit scores can qualify for loans a bank would not consider. P2P platforms require a credit score of at least 600. The good news, though, is that borrowers with good scores can end up paying significantly less for a loan. This is the kind of borrower the P2P investor seeks, and that borrower is usually rewarded.
Is Peer-to-Peer Lending Safe?
P2P lending offers investors the opportunity for significant potential returns. That comes with the caveat that the investor must perform their due diligence. A certain percentage of P2P loans are going to end up as charge-offs, or bad debts, and these percentages are much higher than at banks or credit unions. Most P2P lenders will receive their money back at a good interest rate, but a small percentage will not. It is part of the risk inherent with P2P lending.
Investors can protect themselves by never lending money they cannot afford to lose. Never put all of your investments into the P2P basket, or even one borrower. If you have $10,000 to invest, reduce your risk by making 10 $1,000 loans rather than just one large loan. Frequent well-established P2P platforms with a strong track record of vetting potential borrowers.
P2P lending allows borrowers with good credit scores to receive favorable terms on a loan. The gamified dashboard at SmartCredit can help you take control over your future score, so that you will qualify for lower interest rates, APRs and down payments. With SmartCredit, you can achieve the best possible terms via actionable steps.