What Is Peer to Peer Lending?
Peer to peer lending is a simple transaction between an individual that wants to lend money and an individual that wants to borrow money without the use of a third party facilitator, like a bank or a lending company, to manage the loan. Peer to peer lending is typically limited to basic borrowing and lending, but some peer to peer lending companies are expanding into more complex financial transactions. The first peer to peer lending company in the nation was Prosper, launched in 2006.
Peer to peer lending is becoming more popular as banks limit lending and consumers find themselves facing difficulty obtaining traditional financing. Banks, trying to fix their balance sheets, have introduced much more stringent requirements for personal loans than what was required in the past and fewer people have the qualifications to obtain these loans. Small business owners have been hurt by the contraction in lending as well. The reduction in traditional lending to small businesses has resulted in a dramatic increase in the number of business owners interested in obtaining peer to peer loans.
Peer to peer loans are different than other types of financial transactions. There are no banks or lending institutions administering and supervising the loans, so the borrower pays less in servicing fees for the loan. Loan applications for a peer to peer loan are approved quickly and borrowers are able to access the money that they need soon after the loan has been approved.
The Benefits of Peer to Peer Loans
With peer to peer lending, the borrower is able to borrow money at a lower interest rate than they may have paid for a loan through a traditional lender or credit card company. The funds for the loan are sent to the borrower by check or by electronic transfer after the loan has been fully funded by investors. Payments for the loans are automatically deducted from the bank account of the borrower and deposited into the accounts of the investors that funded the loan.
The loan is comprised of the smaller amounts pledged by the investors and the borrower is charged the lowest interest rate that the investors are willing to accept for the loan.
The interest rate that is charged to the borrower for the loan is determined by the borrower’s credit score. As with traditional loans, borrowers with the highest credit scores receive the lowest interest rates for their loans.
The typical loan period for peer to peer loans ranges between 3 and 5 years. Loans may be funded entirely by a single investor or by multiple investors funding portions of the loan. The minimum investment amount in any one loan is $25, with the average investment amount per investor ranging between $25 and $100.
Borrowers that are interested in obtaining a peer to peer loan have to create a loan profile on the website of the peer to peer lending company detailing their financial situation, the reason for the loan, and the maximum interest rate they are willing to pay for the loan. After the borrower’s information has been validated by the peer to peer lending company, the company will assign the borrower’s profile with a letter grade, used like a credit score to let investors know the borrower’s risk level.
Investing in Peer to Peer Loans
Investors can choose which loans to provide funding for by picking each loan and funding amount personally or using specific criteria to automatically fund loans that fit the criteria. Investors that personally pick loans to fund choose loans by reviewing the listings of the borrowers and focusing on the loans that have the best chance of being repaid and that will provide an attractive return on their investment. After the investor has found the loans that that they wish to fund, they can bid on the loans and commit to funding a portion of the loans if their desired interest rate falls within the range that the borrower is willing to pay.
Loans made through peer to peer lending companies are made on a for profit basis, meaning that the investor lending the money expects to earn a return on their investment that they can pocket. The returns that investors obtain by lending money through peer to peer loans is generally higher than they would realize through more traditional investment methods, such as stocks, bonds, or mutual funds. Investors can diversify their peer to peer loan portfolio with loans of different risk profiles and rates of return. The amount of money risked in each transaction is small, allowing for increased diversity and decreasing the risk associated with the investments.
The borrowers and investors in these peer-to-peer lending programs operate under agreed upon terms that are the result of bidding and counter-bidding, benefiting both parties by arranging a loan that is agreeable to both. The loan application and bidding processes have been streamlined to make completing the loan simple and fast for both borrowers and investors. Analysts expect that the popularity of peer-to-peer loans will continue to increase as long as both borrowers and lenders realize benefits from this type of lending.
Here’s a video about how one peer-to-peer lending company, Peerform, works: