Peer-to-Peer Lending: Is it Safe?

Jul 7, 2020 06:28 AM ET
Peer-to-Peer Lending: Is it Safe?

Peer-to-peer lending is different from a conventional loan that you receive from a credit union or a bank. When you get a bank loan, the bank will use some of its assets, which are deposits made into accounts by other consumers, to fund the loan.

When you choose peer-to-peer lending or P2P lending, borrowers match directly with investors using a lending platform. In this case, investors will have a chance to see and choose the loans they would like to fund. 

What is Peer-to-Peer Lending?

Some marketplace lenders have restrictions on certain types of people who can invest in their loans. For instance, companies like Prosper or LendingClub offer opportunities for everyone, provided you meet the account minimums. However, other companies are only open to accredited investors, or qualified purchasers. People who have a personal income of $200,000 or joint income of $300,000 for the last two years or have a net worth exceeding $1 million can also become credit investors.

However, qualified purchasers have to meet even higher requirements than accredited investors. These individuals should own a minimum of $5 million in investments. Some marketplace lenders only cater to institutional investors. For instance, commercial banks, hedge funds, endowment funds, or life insurance companies.

To generate revenue, marketplace lenders charge borrowers a fee and take a percentage of the interest earned on loan. Generally, lenders charge origination fees to borrowers, which is 1% to 6% of the loan amount, and a penalty for late payments. Lenders take a percentage of the interest accrued on loan, on the investing side. For instance, LendingClub will charge a 1% fee for each payment. Suppose a borrower makes a $300 payment on a loan, LendingClub will charge $3 before it passes the payment on to investors.

Generally, peer-to-peer loans are small business loans or personal loans. Other popular names for peer to peer lending are social lending or person-to-person lending. Companies dealing with peer-to-peer loans are called marketplace lenders or peer-to-peer lenders.

Pros and Cons of P2P Lending

Each P2P lending website works with some rules and regulations and connects borrowers to investors. In most cases, such websites offer a wide variety of interest rates, according to the applicant's creditworthiness. 

P2P lending usually offers higher returns to investors than other investment types. It is more accessible for some borrowers than traditional loans from financial institutions as well. Lending through Peer-to-peer platforms generally come with lower interest rates because of the lower origination fees and higher competition between lenders. 

The lending method provides higher returns, more accessible funding, and lower interest rates, but is that a full picture? However, there are some shortcomings of this type of lending. Credit risk and no government or insurance protection are the main problems for investors in peer-to-peer lending platforms. 

Here are some advantages and disadvantages that peer-to-peer lending offers to both borrowers and investors.

For Borrowers

Pros                      

  • Online and fast experience 

  • Lower interest rates

  • No prepayment penalties

  • Automatic repayment

  • Fixed payments

  • Credit requirements are less strict than conventional loans

  • Flexible use of funds

Cons

  • In case you have below-average credit, then interest rates can go as high as 36%

  • You may not be able to qualify if your credit score is below 630

  • Peer-to-peer lending usually doesn’t offer more than $35k to $49k

  • Missed payments can damage your credit score

For Investors    

Pros

  • Higher yield than CD or savings account

  • Investors get alternative investments outside of bonds and stocks 

  • Most platforms let investors automatically diversify their loan portfolio

  • Sense of community by lending directly to peers

Cons

  • As an investor, you can lose your money if your borrower defaults

  • Some peer-to-peer lending websites are only available to accredited investors

  • This type of lending is nor insured like a CD or savings account

  • Because of the long time horizons, there is less liquidity than bonds or stocks 

Conclusion

Peer-to-peer lending websites serve as financial matchmakers, matching investors with companies or individuals looking forward to borrowing some money. Early on, the P2P lending system was a way to offer credit access to individuals who would not get any loan from a conventional financial institution. However, lending sites are expanding their reach to target consumers looking for a hassle-free way to pay off card debt but at a lower interest rate. 

Moreover, peer-to-peer lending also helps if you are looking for auto financing and home improvement loans. Without a doubt, this is a safe lending system that offers a variety of benefits to both borrowers and lenders. 


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