Peer-to-Peer Lending

Peer-to-peer lending, or P2P lending, is the idea of lending money to businesses and individuals online, through platforms that connect borrowers with lenders. 


What is Peer to Peer Lending?

Peer to peer lending has been around since humans started trading resources. In essence, a Peer-to-peer loan involves one individual transferring money to another, with the intention of earning a profit as compensation for the risk assumed.

Nowadays, P2P lending has evolved to become a booming financial industry, with a global volume of over $34 billion in loans issued during 2018. Its origins in the financial sector can be traced back to 2005, even though it gained significant popularity during the aftermath of the 2008 financial crisis. Individuals looked to these types of loans to access funding quickly, while banks tightened their credit policies to improve liquidity. 

Since then, peer-to-peer loans have become a popular alternative for individuals and businesses looking to obtain funding online, usually at lower interest rates compared to those offered by traditional lenders.

P2P lending is an activity where an individual borrows money directly from another individual. This is often done through online peer-to-peer platforms that facilitate the operation by incorporating features that help the lender evaluate prospective borrowers. 

Lenders have the capacity to screen potential borrowers after assessing their credit history and the conditions of the loan they require. These lenders act as investors who decide to put money into many different loans to constitute a “portfolio” of loans that generate earnings through the periodic payment of interest.

The interest rate charged on these loans usually ranges from 4% to 35% depending on the risk associated with the borrower. The average interest rate in 2019 was around 13.9%. These loans can be used for many different purposes, including financing small expenses, paying for a new car, or even paying college tuition.  

How Does P2P Lending Work?

There are two perspectives of peer-to-peer lending: the investor’s perspective and the borrower’s perspective.

How Does P2P Lending Work for Investors?

Investors who decide to engage in peer-to-peer lending become active lenders in the platform that they pick. They can usually choose from a wide range of prospective borrowers who are looking for funding, and it is their responsibility to assess the borrower’s creditworthiness, their reputation on the platform, and their overall financial situation to pick the proposals that fit the investor’s preferences.

If the investor is risk-averse, he or she will probably pick borrowers with a solid credit history, a high credit score, and a good track record of positive experiences on the platform. On the other hand, if the lender is inclined to invest in riskier opportunities, they may reduce the strictness of their criteria. The returns obtained on riskier loans are commonly higher than those on more conservative ones, as a higher interest rate applies to candidates that are perceived as riskier.

The main risk for those who invest in P2P loans is potential defaults from borrowers. In this sense, certain P2P platforms have reported that the average default rate on these loans was around 4.52% in 2017. 

How Do P2P Loans Work for Borrowers?

Individuals and businesses can easily borrow money through P2P loan platforms by creating an account online and applying for the loan they intend to obtain. They must provide certain information required by the system, including:

  • Their personal information, including their Social Security Number (SSN)
  • Their credit information including credit scores
  • Employment information
  • Other relevant financial information

Borrowers can apply for different types of loans, and the interest rate associated with these loans varies depending on the borrower’s credit situation. Some of the loans offered by P2P platforms include:

Additionally, individuals with bad credit can benefit from P2P loans as the requirements to access one of these loans are commonly less strict than those imposed by traditional lenders.

The Main Benefits of P2P Lending

The benefits vary for both investors and borrowers. These are some of the most relevant advantages. 

Benefits of P2P Loans for Borrowers

  • Low interest rates: With interest rates usually starting at 4% for individuals with a good credit score, peer-to-peer loans are less expensive than other alternatives, and, in some cases, even less expensive than the alternatives offered by traditional lenders.
  • Easy application process: Since P2P platforms operate 100% online, the application process is usually very straightforward, as it mainly requires that the borrower supply basic personal and financial information to start participating in the platform.
  • Credit scores are not as important: Most traditional lenders require credit scores above 660 for borrowers to be eligible for a personal loan. In this sense, peer-to-peer loans are usually more flexible, as some lenders might be interested in extending loans to individuals with lower credit scores due to the higher interest rates charged on these loans.

Benefits of P2P Loans for Investors

  • Portfolio diversification: High net worth individuals and institutions may use P2P platforms as an alternative investment to traditional financial instruments, such as stocks, bonds, or commodities. Considering that these instruments behave in a unique way, they can provide a positive degree of diversification for investment portfolios.
  • Good returns on investment: The median return earned by peer-to-peer loan investors has been estimated as 4.6% per year. Even though the risks involved in lending must be considered, the returns vary depending on the degree of risk associated with the borrower’s credit profile and financial situation.

P2P Lending Regulations

The largest P2P markets in the world are China, the United Kingdom, and the United States. The industry is regulated differently in each country, as the business model is relatively new. Many regulators are racing to bring order to the market to increase its transparency and safety for both borrowers and investors.

In the United States, there are essentially four players involved in regulating P2P platforms. 

The Securities and Exchange Commission (SEC)

The SEC is mainly in charge of overseeing the relationship between investors and security issuers, along with the facilitators that allow the investment operation. From the perspective of P2P lending, the SEC regulates how investors relate with borrowers. 

The SEC has established that investors are not allowed to be compensated directly from issuing a loan to borrowers through a peer-to-peer platform. Instead, the loan must be issued by a bank and the investor becomes a security holder who is entitled to receive the interest payments.

The Consumer Financial Protection Bureau (CFPB)

The CFPB regulates how financial products and services are offered to consumers to protect them from potentially fraudulent operations and scams. They are also in charge of educating consumers to help them understand how P2P lending platforms should work. Although the CFPB does not directly regulate peer-to-peer lending, they carefully review the practices associated with P2P lending to ensure fairness and transparency in this market.

The Federal Trade Commission (FTC)

The FTC intends to promote a fair environment for consumers by protecting them from deceptive practices in the marketplace. More specifically, the FTC regulates how financial products and services are offered and marketed to ensure that the terms and conditions offered by P2P platforms are in line with the expectations and results that borrowers receive from their services.

State Laws and Regulations

In the United States, lending licenses are commonly granted to companies on a state-by-state basis. This means that lenders must apply for a lending license to offer their products in each state. This is a challenge for P2P platforms, which usually intend to operate throughout the country.

Many P2P lending companies have partnered with large banks to provide their services to most states. As of right now, Ohio, Texas, and some other states don’t allow peer-to-peer lenders to operate or issue loans in their states.

What is the Cost of Borrowing Through P2P Lending?

The cost of borrowing a peer-to-peer loan includes the interest rate associated with the loan, along with other fees and expenses. Some of the most common fees applied to peer-to-peer loans are:

  • Origination Fees: Origination fees are flat percentages collected on the nominal value of the loan. They are commonly deducted from the amount transferred to the borrower, or they can also be added to the outstanding balance.
  • Prepayment Penalties: If the borrower wishes to pay for the partial or total amount of the outstanding balance of the debt before it is due, the P2P lending platform may charge a penalty. This penalty is waived by some platforms.
  • Late Payment Fees: The platform may charge a late payment fee if the borrower fails to make their installment payments on time. 
  • Servicing Fee: This is a fee often charged to investors, not borrowers, and it is usually paid monthly or annually for using the services of the platform. It can be a fixed fee or a percentage fee based on the average amount of funds invested.

The cost of borrowing a peer-to-peer loan is usually expressed through what’s known as the Annual Percentage Rate (APR), which is a calculation of the annual cost of borrowing the loan considering other fees, commissions, and expenses, along with the applicable interest rate.

The cost of borrowing a peer-to-peer loan varies depending on the borrower’s credit profile and financial situation. Most P2P lending platforms require that borrowers have a credit score higher than 600 to be considered eligible, and they must also reside in a state where the lending platform is authorized to operate.

The Bottom Line

Peer to peer lending has grown significantly since its inception to become an important source of funding for thousands of individuals worldwide. Investors also benefit from the returns provided by acting as lenders, collecting an interest rate as compensation for the loans they extend. 

While regulators are still working to increase the transparency of the P2P lending market, the largest markets (the U.K., United States, and China) have already created a basic regulatory framework for the industry.

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