What is peer-to-peer lending?

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In a Nutshell

Peer-to-peer lending is a form of online lending that allows individual investors to work directly with people or businesses seeking loans. These individual lenders may get a return on their investment, but they also shoulder financial risk for the loan.
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Peer-to-peer lending connects potential borrowers directly with individual investors who finance loans.

It’s a relatively new approach to the borrowing-and-lending experience. By cutting out traditional financial institutions like banks, borrowers may be able to access funds quickly, and investors might get a healthy return.

Borrowers apply for loans on peer-to-peer lending platforms, while investors select loans that seem like a good risk. An investor can choose to fund a portion of a loan (or multiple loans) individually. Borrowers may receive funds from multiple individual investors.

We’ll review more about peer-to-peer lending platforms, how they work and if they might make sense for your borrowing or investing goals.

What is peer-to-peer lending?

Peer-to-peer lending, also known as P2P lending, is an online system where individual investors fund loans (or portions of loans) to individual borrowers. Also called marketplace lending, peer-to-peer lending is a growing alternative to traditional lending.

Borrowers and lenders can both benefit from this lending system. For example, some borrowers might be able to find a personal loan where they may have been denied by other lenders. And peer-to-peer lending platforms may be a good alternative to payday loans or credit cards for some people.

Depending on your credit, you may qualify for a competitive interest rate. But people with lower credit scores will likely see higher interest rates — sometimes even higher than the average credit card APR.

Though there’s still risk involved, investors in P2P lending may get a better return on their money than they would with some other savings-and-investment opportunities.

Lending marketplaces may help small-business owners as well. The U.S. Small Business Administration said that “peer-to-peer lending may be a viable financing alternative for small businesses.”

How does peer-to-peer lending work?

Peer-to-peer lending uses online software to match lenders with potential borrowers. Features vary from platform to platform, but you’ll find many similarities.

Here’s how the process works if you want to borrow money

  • Fill out an application, which may include a credit check.
  • Review what your interest rate will be if you’re approved. If you want to move forward, you can take the loan into the funding stage.
  • Wait as investors review the loan listing and decide whether to fund it.
  • Move on to the repayment stage if your loan is successfully funded. You’ll make regular payments over the life of the loan. Every payment you make is split up among your various lenders, who each get a proportional share of your payments.

Here’s how the process works if you want to lend money

  • Create an account on a P2P lending platform of your choice.
  • Review loan options. Some platforms will assign a grade to loans to help you gauge their potential risk. You also may be able to set up auto investing.
  • Keep tabs of any earnings in your online account.

What fees do P2P lenders charge?

P2P lending platforms can charge fees to both lenders and borrowers, so it’s important to review the terms of the platform you choose before you accept a loan or hand over your investment dollars.

If you’re a borrower, you may face extra charges such as an origination fee.

What can I use a P2P loan for?

Many peer-to-peer platforms offer unsecured personal loans. This means you can use the funds nearly any way you choose, but most lending platforms do ask you to state the intended purpose of the loan.

Popular reasons for loans include home improvement, medical expenses and major purchases, as well as debt consolidation (take a look at debt consolidation pros and cons if you’re considering this).

The site specifies that loan funds can’t be used for investments, higher education costs, gambling or illegal purposes.

See our picks for the four best peer-to-peer lenders for personal loans.

Is peer-to-peer lending safe?

Peer-to-peer lending might seem like an attractive investment — you have the potential for positive returns on your investments without the involvement of a bank.

But be aware that if you lend money through a P2P platform and the borrower stops paying, the loan may go into default and you may not get paid back. Your P2P investments aren’t FDIC insured.

What’s next?

While you’re deciding whether taking out a loan from a peer-to-peer lender is right for you, make sure to shop around and compare terms. Ask yourself a few questions.

  • Does a loan fit in my monthly budget? Can I pay it back?
  • Can I get a better interest rate somewhere else?
  • How long will it take me to pay back the loan? Is there a prepayment penalty?

With these questions, you can better gauge whether you’re financially ready to loan or borrow through a P2P lending platform.

About the author: Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He has an MBA in finance from the University of Denver. When he’s away from the keyboard, Eric enjoys exploring the world, flying small… Read more.