Peer-To-Peer (P2P) lending is a form of lending in which the borrower receives a loan directly from the lender through an online service. Borrowers include everyday people such as you and I, as well as small companies. The lenders are typically made up of individuals and entities looking to earn a return on the money they lend out. Investors typically invest in notes which is only a portion of the entire loan. This is a defining characteristic of this type of lending in that a single loan is generally funded by hundreds of different individuals / entities and comprised of hundreds or thousands of notes . For example:
John and Sally want to re-finance there credit card debt and apply for a loan in the amount of $10,000.00
There is a $25.00 minimum each individual / entity can invest into a note.
Therefore if everybody chooses the minimum ($10,000.00 / 25 =400) there will be a total of 400 individuals who finance John and Sally’s loan.
In many cases each individual will stick to the minimum loan amount in order to better diversify there loans / notes. More on this later.
What is the benefit of peer lending?
- It’s all done online. This greatly reduces overhead costs and allows companies who facilitate the crowd lending (AKA P-2-P lending) process to pass on the savings. Compare this to the brick and mortar financial institutions who have to cover the costs of maintaining buildings, staff and other tangible assets.
- You can choose to invest in loans based on how risky they are. Lower risk loans earn less interest while higher risk loans earn more interest.
- Just like a bank, you receive monthly payments on your note in the form of principal and interest. In some cases you even receive late payment fees.
- It utilizes software that allows borrowers to filter different loans based on factors such as income, credit score, whether or not they own or rent, how long they have been employed, and many other factors.
- It can be a fully automated process. Many companies now offer an option to automate your investing allowing you to dictate how much you want to invest per loan, and what criteria the loan must meet in order for the software to actually make the loan.
- With the ability to automate your investing you can choose to be as active or passive as you want when investing in notes.
- You can sell your notes on a secondary market. This is handy in the event that you need to liquidate your position.
- Applying online is quick and easy (assuming you have all the pertinent information you would need to apply for a standard bank loan). Turn around times are typically around one week. If your lacking information and documents it can take as long as fourt-five weeks depending on the lending platform.
- Rates are extremely competitive. As previously mentioned, the entire process is done online and lending platforms have low overhead when compared to brick and mortar financial institutions. This enables them to pass on the savings in the form of lower interest rates.
- One of the primary reasons individuals take a peer to peer loan is to refinance there credit card debt.Depending on your credit and other qualifications you can typically get a much lower rate than what your credit card company is currently charging you. This gives individuals a significant advantage when trying to consolidate debt into a lower monthly payment.
- Loans come in three year (36 months) and five year (60 months) increments allowing some variation in the length of the loan which in turn effects how big your monthly payments will be.
- Your loan is typically funded by hundreds of people and not a big corporate bank.
What are the risk factors associated with peer lending?
- The loans you make are unsecured. This means there is no collateral in the form of a tangible asset backing up your money. As compared to a home loan in which case the bank can foreclose for non payment and sell or auction your house to recover the principal, you have no guarantees if the entity who borrowed your money decides to stop paying. Crowdfunded loans are all based on credit scores, income, and other qualifying factors. This form of investing is on the higher end of the risk spectrum.
- Companies who facilitate the loans and investments opportunities can fail. At the core of this whole crowdlending process there are companies who take a small cut of the money being exchanged between lenders and borrowers. They in turn provide the online marketplace where borrowers are vetted, payments are processed, etc. These companies are for profit and some are even publicly traded. In the event one of these businesses goes under, there are typically plans in place for a financial services company to step in and take over the notes. However, this would certainly create a less than ideal situation for investors and borrowers as there would undoubtedly be more inefficiencies and likely additional fees to cover the expenses of the backup financial services provider. At least there is a fail safe.
- The notes you want to invest in aren’t always readily available. There is currently a disparity between the number of investors and money available to invest versus the number of borrowers and money being borrowed. Currently there are more investors and more money than there is people borrowing. With the addition of large financial institutions starting to invest via peer lending as well the gap is pushed that much more. This is good for borrowers but bad for investors. The good news though is that companies are now marketing in mass to individuals and companies creating a much larger pool of borrowers.
- P2P is the greenhorn of the financial sector and with all new investment vehicles it’s still yet to stand the test of time. It got its footing around 2007 and while it has seen a very devastating decline in the market in the form of the 08 crash, it’s market share was much too small to really matter. Were talking millions of dollars during the great recession where as now its market share is well into the billions.
- While P2P beats the hell out of a payday loan or credit card interest rates they can still be very high. Don’t apply thinking a peer loan is your only option. While it’s true you can get great interest rates if you have great credit, it’s also true that bad credit equals a bad interest rate. Don’t get sucked in just because you applied and got approved. Shop around.
- While most peer loans are unsecured (meaning there’s no collateral or assets the lender can liquidate in the event of non payment), they won’t magically go away if the borrower stops paying on there loan. The fact is loans stay with the borrower until they either file for bankruptcy or reach a settlement with the lending company which can be a long and frustrating process.
- It turns out that people who lend out there money want it back. With interest. If the borrower is late paying they can expect late fee’s just like a bank or payday loan company would charge.
- While it’s easy to apply it can sometimes take weeks to get approved and even longer to get a loan funded. If a borrower provides the bare minimum information when applying it takse longer to verify the application. Additionally, as the loan is likely going to be funded by a multitude of individuals it takes time to get fully funded. In some cases the loan might get 90% funded only to be canceled because it didn’t reach the full amount which is required to receive the loan.
- Borrowers can be denied or fail to acquire a loan because it wasn’t fully funded. If someone doesn’t meet the qualifications set forth by the lending company they will be denied plain and simple. Unfortunately for borrowers this can show up on your credit history making acquiring a loan from other companies even harder. This is due in part to other companies scrutinizing your application more vigorously because you were already denied which raises red flags. It implies that there must be something wrong with you even if the lending company you just applied with had really high standards.
As someone who loves technology and the simplifying of otherwise complex financial processes I think peer lending is a great tool for both investors and borrowers. It gives individuals a chance to tap new investment opportunities while giving borrowers a streamlined borrowing opportunity. What do you think? Let me know in the comment section below!