What is P2P?
In recent years, lenders looking for small loans with friendly interest rates have turned to peer-to-peer lending (P2P) as a way to sidestep big financial institutions, helping P2P investing become one of the fastest growing segments in the financial industry.
Sometimes called “social lending” or “crowd lending”, P2P connects borrowers directly with investors through an internet platform – completely cutting banks out of the lending process. The lower operating costs and interest rates have made P2P a major competitor for the traditional banking system – and an appealing option for borrowers hunting for low interest personal loans and lenders looking to diversify their investment portfolios.
Borrowers tend to be people looking for unsecured loans of $1,000-$35,000 payable over 3-5 years, who don’t have access to home equity credit. These are often to help pay for small purchases - a used car, home repairs, and so on - or to consolidate their debt with a lower interest loan. Lenders tend to be individuals investing from $5,000 to $25,000, spread across a series of small, $25-$100 loans to minimize default risk. They are looking to sidestep banks and find investments that pay higher than traditional methods such as bank accounts and Certificates of Deposit (CDs).
Loans For Small Purchases, From Your Smartphone
One of the main draws for P2P lending is the customer experience, and the large number of lending companies consumers can choose from. Borrowers can shop interest rates without leaving the house and lenders can track their portfolio with a few clicks on their smart phone. Both lender and borrower can bid adieu to long lines at their local bank branch, where approval for a loan can take days rather than mere minutes on a P2P platform.
Lending companies make their money by charging fees to borrowers, taking a percentage of the loan repayments to investors, and collecting fees for defaulted loans, in addition to other service fees.
We recommend potential investors and borrowers read reviews of some of the industry’s top P2P platforms, including SoFi and LendingTree.
What to Consider:
Although P2P lending provides significant advantages to both investors and borrowers, you still need to do your homework. One thing to note is there are fees involved – including origination fees - that can range from 0.5% to more than 5% of the loan. Be sure to read the fine print and fully understand the total cost of the loan by the time it’s paid off.
Late fees can get expensive if you don’t make your payments on time. For instance, sites like Guide to Lenders and Lending Club charge 5% or $15 for payments that are 15 days late or more, as well as a $15 processing fee for checks.
Some lending companies charge contributions to “bad-debt provision funds” – which are set aside to help protect the lending company from losses. Because the loans are taken out with no collateral, P2P companies can sell the defaulted loans to a collection agency or take out a court order against the borrower.
Rise in Interest Rates
An average interest rate of a peer to peer loan is roughly 15% but if you have fantastic credit you can get rates as low as just over 5%. That said, those with poor credit can get stuck with much higher interest rates – as high as 30.99% for the riskiest borrowers at Lending Club – an industry leader.
Experts believe that if interest rates continue to increase, the industry could see higher costs for borrowers – and better returns for investors – perhaps leading to a bubble in the industry. Regardless, average interest rates on P2P loans are not likely to exceed those of credit cards, and as long as the economy is doing well and unemployment remains relatively low, the number of defaults shouldn’t raise any red flags.
Most peer to peer loans are only three to five year, fixed monthly payments, though many loans are stretched out over a longer period, with lower monthly payments and higher interest rates. This is yet another reason these loans are becoming favored - low interest with a fixed term for the repayment.
Bad Credit? No Problem
Prior to 2008, lenders were focused on borrowers with credit scores over 640. Today, some P2P sites are welcoming borrowers with scores as low as 580, though they stand to pay higher interest rates than lower risk borrowers. In addition, some P2P lenders look beyond just your credit score, factoring in considerations such as work history.
Prior to 2008, P2P was relatively new to the industry and lenders had fewer regulations than their industry counterparts. In 2008 however, the Securities and Exchange Commission began to regulate the P2P industry and on the borrower side, agencies such as the Consumer Financial Protection Bureau and Federal Trade Commission now regulate the P2P industry. P2P platforms are subject to the same federal rules that govern all consumer credit company such as Equal Credit Opportunity Act and Fair Debt Collection Practices Act and borrowers are protected by state regulations against misleading advertising and discriminatory practices.
In 2016, growth for the P2P industry began to stumble under heightened regulation, leading many financial analysts to question predictions that the online lending platform poses a threat to traditional banking. Nonetheless, the industry is still on the rise and P2P loans remain an inexpensive way to tackle multiple debts at once and help you make your dreams come true. We just want you to make sure that it is something you are prepared for and ready to face head-on.
Pros for lenders:
Peer to peer lending platforms help lenders find borrowers based on credit score and credit risk. (A higher credit score means a lower lending risk, but also a lower interest and potential gains for lenders). P2P platforms can provide lenders with a wide range of low and high risk borrowers and allow them to spread their loan out to dozens, hundreds, or even thousands of investors, diversifying their investment and lowering their default risk.
For lenders, peer to peer loans provide an investment opportunity that can often yield better results than more traditional investment routes like stocks, bonds, CDs, and the like. Opening an investment account online is simple and painless, and a lender can start with low-risk investments as small as $25. As the loans are repaid, lenders have the ability to reinvest the payments into new loans or withdraw them from their P2P account at any time. The freedom and ease of running P2P portfolios is a major draw for investors and one of the principal reasons for the growth of the industry.
Pros for borrowers:
For borrowers, the P2P process can be a faster, easier way to receive unsecured loans that don’t require collateral such as a car title. They can also stay anonymous to their lender and receive lower interest rates than they would through a financial institution or credit card.
The user experience is often more positive as well – borrowers and investors alike can follow the progress of their account online or from the comfort of their smartphone, wherever they may be.
Cons for investors:
Even if you diversify your portfolio across hundreds or thousands of loans, you can still lose your money – if you aren’t cautious. Higher risk loans do yield greater returns, but wise investors know to spread such loans across a wide portfolio in order to offset risks. In addition, investors are not allowed to cut their losses and sell the loan ahead of time – they are bound to the commitment made at the time of lending. Furthermore, whereas bank deposits are guaranteed repayment by the federal government in case of borrower default, peer to peer lending is viewed as an investment in the US, meaning that lenders may be left hung out to dry.
With the lower interest rates for peer to peer loans, lenders stand to profit far less off borrowers than credit card companies and other traditional lenders, while still facing default risks. Furthermore, since their loans tend to be diversified across a wide range of borrowers, lenders cannot expect to perform due diligence on each and every borrower, and have no choice but to rely on the assessments and algorithms of the P2P companies, which have not been in business long enough to establish a long history of successfully estimating default rates.
Cons for borrowers:
Those who turn to P2P because of a low credit score will find themselves facing high-interest rates, sometimes higher than those on credit cards. And even though borrowers don’t have to put up collateral, they risk severe harm to their credit rate if they are not able to pay off the loan at the scheduled time. In addition, fees involved in processing loan payments – especially late payments –can add up over the lifetime of the loan.
So, what’s next?
It’s up to you to determine if a peer to peer loan is the right way for you to get on the road to being debt free or a ticket to higher returns on investment than your bank account or CD. With a little homework and some caution you can take part in an industry that is user friendly and has great potential for reward – all from the comfort of your home. For more information on P2P loan providers, read our reviews of top companies.