What is peer-to-peer lending?

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In a Nutshell

Peer-to-peer lending is a system of lending and borrowing without a big bank or other institutional lender involved. Individual investors fund loans for borrowers and get a return on their investment — but they also shoulder the risk for the loan.

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Peer-to-peer lending takes the institution out of the banking equation and allows borrowers to connect directly with individual lenders who fund loans in small increments.

It’s an innovative approach to the borrowing-and-lending experience. By cutting out banks, borrowers can access funds more quickly and investors can earn more than with the traditional banking-and-lending system. Borrowers apply for loans on popular peer-to-peer lending platforms, while investors choose loans that look like a good risk. An investor can choose to fund a portion of a loan (or multiple loans) individually. So instead of having their loans underwritten and approved by one banker, borrowers can receive funds from multiple individual investors.

Today, getting a loan from a peer-to-peer lender offers few functional differences to the experience you would have using any major online lender. But with a unique funding model, loans in the peer-to-peer industry are anything but typical.

Learn more about peer-to-peer lending platforms, how they work, and if they make sense for your borrowing or investing needs.


What is peer-to-peer lending?

Peer-to-peer lending, also known as P2P lending, is a technology-enabled 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 more-direct lending system. For example, some borrowers might find that they’ll 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 borrowers. Depending on your credit, you may qualify for a very competitive interest rate. But borrowers 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 find they’ll get a better return on their money than they would with some other savings-and-investment opportunities.

Lending marketplaces are important for small-business owners as well. The U.S. Small Business Administration found 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 borrowers. Features vary from platform to platform, but you’ll find many similarities. Industry leaders include Lending Club and Prosper.

As a borrower on a peer-to-peer lending platform, you fill out an application that may include a credit check. After learning what your interest rate will be, you can choose to move forward and take the loan into the funding stage. During the funding period, investors review the loan listing and can fund the loan in increments, which typically start at $25 per investor.

If the loan successfully funds, you’ll move on to the repayment stage. Just like you would with a loan from a bank or credit union, 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.

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.

Types of loans available through peer-to-peer lending

Many loans through peer-to-peer platforms are 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.

Lending Club offers 11 specific options for loan purpose in its application. Popular reasons for loans, according to Lending Club, include debt consolidation (including credit cards), home improvement, medical expenses and major purchases. The site specifies that loan funds can’t be used for investments, higher education costs, gambling or illegal purposes.

Loan terms available through peer-to-peer lending

At Lending Club, loans come in 36-month or 60-month terms. Longer-term loans often have lower monthly payments, but you’ll likely pay more in interest over the life of the loan.

Business loans may have different rules from personal loans on peer-to-peer lending platforms though. Popular marketplaces for business loans include Kabbage, OnDeck, Funding Circle and Lending Club.

Pros and cons of peer-to-peer lending

Borrowers

As a borrower, peer-to-peer lending can offer a valuable alternative to payday loans and credit cards. If you have a wide range of high-interest credit card balances, for example, refinancing to a lower-interest loan through a P2P platform can save you money while putting a clear payoff date on the calendar.

On the flip side, if you don’t have a strong credit history, borrowing through P2P lending can still cost you. Credit scores are a big factor in determining your interest rate. If you don’t have great credit, you may be able to find cheaper borrowing options than marketplace lenders.

Personal loan with bad credit: Proceed with caution

Lenders

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 goes into default and you may not get paid back. It takes a diverse portfolio to succeed in P2P investing. Just like with stocks, you should never keep all of your eggs in one basket.

FAST FACTS

Do peer-to-peer investment results depend on the borrower paying back the loan as promised?

Lending Club reports a median return of 4.3% — less than the S&P 500’s annualized yearly return (1928–2017) of 11.53% — for investors who have at least 100 loans (also called notes) in their portfolio. The platform indicates that those with fewer than 100 loans have a much higher risk of investment losses.

As with any investment, you should research the risks and review the details of your investments before getting started.


Bottom line

Peer-to-peer lending offers a unique platform for borrowers and lenders to get results from a technology-driven financial system. But fees, along with potentially high interest rates, could make P2P lending more expensive than traditional investment systems for some.

Still, borrowers could benefit by considering peer-to-peer loans among several other types of loans when shopping around. It might be the best deal, but it might not. Don’t commit to any loan until you’ve taken the time to compare several options.

As an investor, peer-to-peer lending may be a good fit in your portfolio. Read into the typical return for different portfolios if you want to add marketplace lending to your overall investment plan.

Are peer-to-peer loans right for you? It depends. But they’re certainly worth a look.

Learn more: Personal loans from online lenders … good or bad idea?