What is Peer-to-Peer Lending?

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What is Peer-to-Peer Lending?

There are many reasons people turn to peer-to-peer loans, a way to lend or borrow money from people without having to go through a traditional financial institution like a bank.

You might have a business idea that traditional banks won't fund. Or you may have high-interest rate debt that you want to refinance. If you're in a situation like these, a peer-to-peer loan might be the answer.

The History Behind Peer-to-Peer Lending

Peer-to-peer loans are relatively new to the lending scene. Prior to the Great Recession in 2008, if you needed a personal loan you most often had to secure it from a brick-and-mortar bank.

During the ensuing financial crisis, banks became more hesitant to extend loans, forcing people to look elsewhere for funding.

Peer-to-peer lending is doing for personal and business loans what Uber did for the transportation industry -- it's connecting individuals who need something directly to those who can loan it out. Borrowers get the funds they need, while lenders have the potential to earn higher returns than, say, a traditional savings account.

How Does Peer-to-Peer Lending Work?

You fill out an application on a peer-to-peer lending site, such as our marketing partners Prosper and Lending Club. Once the site determines how risky you are as a borrower, your loan request will be approved or rejected. These sites typically determine your risk by assessing things like your income.

If you're approved, your loan gets funded through the contributions of one or more interested investors.

On the lending side, the process of becoming an investor is generally very simple; you open an account, transfer the funds and start funding loans at the desired interest rates and amounts you see fit. Typically, most P2P sites require that you invest at least $2,000.

Pros and Cons of Peer-to-Peer Lending

There are many factors to think about when considering peer-to-peer loans. Evaluating the pros and cons and how they impact your particular situation can help you make the decision that's best for you.

Peer-to-peer loans benefits include:

  • Applications typically result in soft inquiries, which don't impact your credit score.
  • Funds can be available in a few days instead of the potential two-week wait you'd experience at a bank. For example, according to Lending Club, the average time it takes for funds to be issued to the borrower after they've listed the loan is 7.5 days.
  • There's typically no prepayment penalty, which means that if you pay back your loan early, you aren't charged a fee.

Peer-to-peer loans aren't perfect, though. Some drawbacks can include:

  • They're not available in every state, due to variances in state law.
  • You may not get the entire amount you ask for since funding requires securing loans from multiple investors and presenting yourself as a good candidate. Depending on which platform you choose, if your loan isn't fully funded within the initial period, you may have to create a new loan request or settle for a partially funded loan.
  • Most P2P lenders specify maximum loan amounts - for example, Lending Club and Upstart have maximum personal loan amounts of $35,000.

Who is marketplace lending best suited for?

At this point, you may be wondering if peer-to-peer lending is something you should consider. These loans can be especially suited for certain groups of people:

1. Consumers with high-interest rate debt. Peer-to-peer loans could potentially help lower the overall rate you're paying. For example, Lending Club and Prosper can offer interest rates on personal loans as low as 5.32 percent APR, compared to the average credit card interest rate of about 15 percent.

2. New business owners. Getting approved for a small business loan through a traditional bank can be challenging. You might find more willing lenders in the marketplace lending space.

3. Consumers with multiple lines of debt. If you're having trouble managing multiple payments each month, a peer-to-peer personal loan could help consolidate your credit cards and other loans into one manageable payment.

Bottom Line

While the marketplace lending space is relatively young, it's mature enough to offer appealing solutions. When you need a loan and can't find a willing traditional or institutional partner, peer-to-peer lending may be the solution you're looking for.

About the Author: John Schmoll, MBA, is a former stockbroker and veteran of the financial services industry. He left a career with a well-known brokerage house in 2012 to grow an advertising business with his wife, write about finance and start a personal finance site, Frugal Rules. His work has been featured in Forbes, Fortune, U.S. News & World Report, Yahoo!Finance, CNBC, Daily Finance and more. Follow John on Twitter.

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