Peer to Peer (P2P) Lending Basics (For Borrowers)

What is P2P Lending?

Things do change very fast in the financial world.  Take the case of loans, especially on the lending side.  There’s a recent upsurge in the popularity of peer to peer loans in the market.  But what is peer to peer lending?

Peer to peer (P2P) lending is an innovative way to make funds available to borrowers without having them go through traditional banks or credit unions.  So, if you’re looking for a lender, you’d better take a look at a few P2P lenders as you do your search.

If your credit score is high, you might be in for a surprise:  many P2P lenders charge lower rates for your class of borrowers.  If your credit score is questionable, don’t despair.  You still have a chance of getting an approval for an affordable loan with these non-traditional lenders.

In this chart compiled with LendingTree customer data, you can see that those with a 720+ credit score pay an average of 7.63%. At the other end of the scale, for those with a poor credit rating of less than 560, the rate shoots up to an eye-watering 113%.

Funding For P2P Loans

Funding for P2P loans come from different individuals and investors while in traditional loans, it comes from the bank’s or credit union’s cash assets.  In concept, peer-to-peer lending is simply like lending money to family and friends except that it’s on an industrial scale.  The different P2P websites have one common purpose and that is to match lenders and borrowers for their mutual benefit.

Basically, it’s about people with extra money who are willing to lend them to parties (individuals or businesses) who are in need of cash.  A P2P server, which commonly comes in the form of a website, efficiently does the matching process which makes it convenient for all parties in the transaction.

Here's the interesting part: the lenders aren’t professional moneylenders or loan sharks. They’re often regular people with savings who are looking for a reliable return on their money. The borrowers, on the other hand, are individuals or businesses in need of urgent cash. They've gone through a thorough vetting process to ensure they’re capable and committed to repaying the loan.

How P2P Lending Works

If you are familiar with the process of borrowing from a bank or credit union, you have to unlearn quite a lot of things when it comes to P2P borrowing or lending.  The process is a lot different than the traditional way to get a loan.

In a bank loan, the bank will let you borrow directly from the assets that the bank accumulated through their many depositors. This means that you are borrowing funds that the bank technically own and their depositors do not exactly know who the bank is lending the money to. In peer-to-peer lending, the lending platform matches the borrowers directly with investors.

Investors can see, examine and select the loans that they want to fund or invest in.  So, you may surmise that peer-to-peer loans will commonly be personal loans or small business loans because of their size and nature.  Other terms for peer-to-peer is person-to-person lending or social lending.  People in the finance community call these companies that invest through these loans as peer-to-peer lenders or marketplace lenders.

What Can I Use a P2P Loan For? 

With a P2P loan, you have multiple options on what you can do with your loan. For a start, you can use your loan for business investment. If you need some cash for your home improvement, they have a perk for that.

They also offer loans to cover medical bills. And if you are a student, you can use the loan to cover your tuition fees. In case your goal is to buy a car, you can also access auto loans. Generally, since different P2P lenders have diverse terms on what they are willing to finance, you should find out if you can get finance for your specific need.

Personal loans offer a flexible form of finance, as they can be used for practically any purpose. In this chart compiled from LendingTree consumer data, you can see that debt consolidation is the most common reason for taking out a personal loan. The least common reason is for home improvement. This is likely due to more advantageous products that can be used for home improvements such as home equity lines of credit.

Each Marketplace Has Its Own Conditions

Some marketplace lenders try to control the quality of their investors by accepting only those who can meet their requirements.  Many of them are available even more to everyone so long as they can meet the minimum criteria.  LendingClub and Prosper are examples of this kind.  Other companies are more selective and only accepts accredited investors or qualified purchasers.

To get in as an accredited investor, you should have a personal income of $200,000 or $300,000 if it’s a joint income for the last two years.  Or, you should have a total net worth of more than $1,000,000, individually or jointly. Not easy at all – considering the risk investors take. To become a qualified purchaser, the requirement is even more demanding than for an investor.

You should have an investment portfolio worth at least $5,000,000.  The last type of marketplace lenders only accepts institutional investors such as hedge funds, commercial banks, life insurance companies and pension or endowment funds.

P2P Lending Vs Crowdfunding 

The main difference between crowdfunding and P2P lending is how lenders request funds from the public. P2P lending is a purely loan-based model. In comparison, crowdfunding raises funds through equities or rewards.

With crowdfunding, investors raise money to grow a business idea, and then get a stake in the business. If the business succeeds, the investors stand to earn a return on their stake. However, if a business fails to pick up, the investor could lose their investment, and the business owner is under no obligation to repay the money.

P2P lending is a type of lending where investors’ funds are matched with individual borrowers or businesses through an online platform. Rather than owning equity in the business, investors act as lenders and earn interest over a set period. The returns and risks are generally moderate, and there's a lower chance of losing money.

How Do These Marketplace Lenders Earn?

First, they charge certain fees to borrowers.  Second, they get a percentage of the interest on the loan.  The most common fees are origination fee (which usually runs from 1% to 6% of the principal) and late payment fee.

On the investor’s side, the lenders will get a cut off the interest that has accrued on the loan.  LendingClub, for instance, gets 1% of each payment amount so if a borrower pays $200 on a loan, LendingClub takes $2 and passes the net amount to the investors.

How to Choose The Right P2P Lender?

More and more companies are joining the marketplace lending bandwagon.  With the entry of Prosper and LendingClub in the market, the concept caught fire and grew.

In any case, look up each lender and read independent reviews about them before you apply for a loan.  Each lender will require you to provide some sensitive information such as your Social Security Number so you don’t want scammers in the guise of a P2P lender to get your information and use them for identity theft.

There are also other lenders that flood the market and some incredible finds may be less “pure” P2P lenders.  So, when you borrow from them, you do not borrow from individual lenders but from other non-bank lenders.  These online loans get their funding from different types of investors – it’s quite surprising that there are major banks that invest in these enterprises.

Pros of P2P Borrowing

The rise in popularity of P2P borrowing stems from its many advantages over traditional loans or credit cards.  Here are the obvious ones:

• Convenient and quick application process via online
• Does not affect your credit score as traditional loans when you shop around for good interest rates
• The possibility of getting a lower interest rate compared to credit cards and traditional loans
• Clearer interest rates and monthly payments because there are no hidden fees
• You remain anonymous to your lenders so they will not contact you directly to demand payment
• Generally, there is no prepayment penalty so you can repay your loan ahead of time
• There is no collateral requirement for your loan (so you can keep the title to your car with you)
• There is a “social” dimension to the process as you get to watch online investors fund your loan until they reach the principal
• You can transition to traditional loans if you handle your initial online loan remarkably well

Cons of P2P Borrowing

It’s easy to fall for the many advantages of P2P loans but before you get into it, check out some of its disadvantages:

You can’t borrow your way out of your debts

Investment and chartered financial analyst Joseph Hogue reveals that many borrowers avail of P2P loans for debt consolidation.

However, easy access to loans does not always remedy the problem of debt – it may backfire if the person does not fix the root cause of the problem.  If a spending problem is the culprit why you are saddled with too much debt, then you should fix it first.

You have to settle with higher rates

If you have a not-so-ideal credit score, you’d probably be left with no choice but to select among high interest offers that will prove more expensive as the months go on.  Here’s a trick you can consider:  Wait and try to improve your credit scores first before you apply for another loan.

Bad credit means kissing your chances of a loan goodbye

Here is a most important truth:  lenders would not lend to borrowers with credit scores below the cutoff.  Borrowers with credit scores at the low end would have about 25 to 35 percent chance of getting a loan.  Some credit cards might have a less burdensome interest rate for cases like this – be sure to weigh things carefully.

If you mishandle your P2P loan, it’s going to hurt

Yes, you got a loan without having to provide security for it – the temptation to pay it last among your other obligations is great indeed.  If you miss a payment, the effect to your credit score will be similar to missing a payment on any other type of loan.  And because P2P investors take pains in evaluating who they lend to, you might permanently ruin your chances at getting another loan.

Very low loan ceiling doesn’t help much for bigger needs

Many investors won’t allow you to borrow more than $40K (in some cases, $35K).  So, if your need is bigger than those limits, it means sourcing for other options or totally putting P2P aside for the moment.

Applying For a P2P Loan

The usual practice for lenders is to let you check the interest rate that will apply to your loan and do the application process online.  Under normal conditions, the entire process will only take a few minutes.  However, you should keep in mind that each lender has their own requirements.  If you are applying for a personal loan, they will need your credit score, debt-to-income ratio, salary details, employment status and of course, credit history.

If you are applying for a business loan, they will look into how long you’ve been in business, personal and business credit score, debt service coverage ratio, income & expenses, and profits.  As a rule, lenders will only lend to you if you are at least 18 years old and live in a state within their service area.  You must have a bank account they can verify and a Social Security Number.

Like traditional loans, you’ll have to provide the lender with your personal information including your name, permanent address, birthdate, phone number and email address.  If it’s a personal loan, you have to provide details on your housing or mortgage payments, other outstanding obligations, employment status and salary, educational history and perhaps some explanation regarding the loan that you are applying for.

P2P Loan: The Approval Process

You might need to present some documents to back up these details so prepare a photocopy of your I.D., pay slips or W-2 forms.  If it’s a business loan, the same principle will apply so be ready with a copy of your recent tax returns, a financial statement such as your balance sheet and income statement.

Once you’ve got that nailed and the application reaches your lender, they may present you with several offers.  Supposing that you pick one of their offers, you will have to allow them to do a hard credit check.  Take note that this might already affect your credit score.

The helpful advantage is that these peer-to-peer lenders have a quick turn-around time.  You normally won’t have to wait for a week – some of them get back to you on the same day with a decision.  Funding is also really fast.  Most borrowers receive their funds within 2 days to 2 weeks.