Peer-to-Peer loans are innovative financial products that allow individuals to lend and borrow money between each other, usually through a platform that handles the interaction and relationship between the parties involved in the transaction.
What Are Peer-to-Peer Loans?
In its most basic form, a peer-to-peer loan is an IOU. This means that an individual who lends money to someone else is, in fact, producing a peer-to-peer loan. Nevertheless, this term has been adopted by the financial industry to define the services provided by certain financial companies that offer a platform where individuals can negotiate and settle peer-to-peer loans between themselves.
Peer-to-Peer Loans Benefits
The banking system traditionally operates by utilizing the money deposited by individuals and businesses to extend loans to clients who are qualified to receive and repay them as agreed.
In this sense, the bank acts as an intermediary between depositors and borrowers while also collecting an interest rate as compensation for their involvement.
Peer-to-peer loans cut the middle man from the process and produce a higher return on the funds invested by the depositor (in this case, the lender). Another benefit is that they are also usually less expensive for the borrower—even though that’s not always the case.
On the other hand, there are other benefits and downsides associated with peer-to-peer loans, including:
For Individuals Who Lend the Money through Peer-to-Peer Loans:
- Higher compensation for the funds invested
- The possibility of analyzing the person’s credit record through a third party
- The chance to build a portfolio that focuses solely on peer-to-peer lending as an alternative to traditional investment opportunities such as stocks, bonds, or mutual funds
- Average default rates are between 3% to 4%, according to one of the largest peer-to-peer lending platforms in the world
- The risk is significantly higher than that of investing in a certificate of deposit (CD) or a traditional savings account
- The regulations are still evolving, and, therefore, lenders could see a shift in their returns
- The invested funds are not secured by the Federal Deposit Insurance Corporation (FDIC)
For Individuals Who Borrow Money through Peer-to-Peer Loans:
- Conditions are less strict compared to those required by traditional lenders
- A lower cost of borrowing compared to those of payday lenders
- Credit situation has less impact on creditworthiness as third-party platforms also provide customized credit assessments and a reputation system of their own
- No need to go through lengthy paperwork or walk to your local bank’s branch as peer-to-peer lending platforms are 100% online
- Peer-to-peer loans are unsecured, so no collateral needs to be used
- The cost of borrowing may be higher than traditional financial institutions
- The maximum limit you can borrow is usually lower than the limits offered by traditional lenders
- As a financial technology, peer-to-peer loans have risks associated with the platform’s capacity to handle payments and disbursements efficiently. There could be excessive charges or processing delays that may affect the borrower’s ability to obtain or repay the loan on time.
Reasons Borrowers Apply for Peer-to-Peer Loans
On certain occasions, a peer-to-peer loan might be more attractive for borrowers than traditional personal loans. Some of these instances are:
Individuals with high credit card or consumer debt could use peer-to-peer loans to consolidate their debt at a lower interest rate, especially if they have a healthy credit situation.
Non-Traditional Use of Funds
Most traditional lenders will extend loans based on a particular necessity, such as a car loan, a mortgage, or even home improvement loans. A borrower, on the other hand, might be looking to obtain a loan to fund other types of transactions such as weddings, medical bills, or other unexpected expenses.
Peer-to-peer loans rarely require that the borrower discloses the exact destination of the funds, as they are considered to be unsecured loans with no collateral attached to it. These loans are extended based solely on the creditworthiness of the borrower.
Borrowers with Little Credit Experience
It may take a while for a borrower to build their credit score since they are built based on the track record of individual credit accounts. Peer-to-peer lending could provide a faster track to obtain small amounts of unsecured debt to cover for any short-term financial need.
The Cost of Peer-to-Peer Loans
The most frequent fees and expenses associated with borrowing a peer-to-peer loan are:
- Origination Fee – This is commonly a fee that is taken by the third-party platform to facilitate the transaction. The fees usually range from 1% to as much as 10%.
- Late Payment Fees – Late payments are usually penalized through a fixed amount along with an interest charge on the amount of the delayed payment(s). The interest rate imposed on these penalties can be equal or higher than the initial rate set for the peer-to-peer loan.
- Interest Rates – The APR of peer-to-peer loans in the United States ranges from 7% to 36% depending on the borrower’s credit situation, their experience, reputation on the platform, and the dynamics of supply and demand.