Peer to peer lending is a recent phenomenon. Users of these platforms seek peer to peer loans as an alternative to traditional lending.
But there are also specific advantages and disadvantages of using them.
In this article, we will go over:
Peer to peer lending (P2P) is a form of direct lending. It enables individuals to borrow money from willing individual lenders, cutting out the intermediaries. You may also refer to P2P lending as “social lending”.
The concept of peer to peer lending is fairly young. It’s a specific form of lending that is facilitated by modern financial technology. Most such services are offered by P2P lending websites.
There are two parties to most traditional loans:
P2P lending is much the same, except it is between two individuals or businesses, not one individual or business and one:
An investor opens a new account on a P2P lending website. They deposit the money they want to use as their investment. They agree to have that sum dispersed as loans to borrowers on the same site.
A loan applicant also opens a new account on the P2P lending site. As with traditional lending, they have a risk profile. A risk profile is based on factors such as credit score, debt-to-income ratio, and other traditional credit risk assessment factors.
Now, both users are on the same site. The site’s entire purpose is to connect the two parties. The site also sets the rates and terms acceptable for transactions.
The borrower looks through all the offers on the site. They can review as many applicable offers as they like. Or, sometimes, the borrower breaks up their search into multiple chunks, accepting multiple offers for the same sum.
In this case, our borrower finds the investor and borrows from them. The peer to peer lending platform connects these two individuals.
Once the loan is agreed upon, the P2P lending site handles the money transfer. Then, all the repayments are also facilitated through the site. Depending on the site and circumstances, the repayment process may be completely automated.
Sometimes, the investor (lender) and the borrower will negotiate before coming to an agreement.
The borrower repays the lender-investor according to the terms they agreed upon. Ideally, both parties are satisfied.
Imagine you want to invest your money into a (relatively safe) debt instrument.
As an individual, you can lend money to a bank, which in turn lends that money to borrowers at a higher interest rate. Some such individuals want a higher rate of return than they would get from most savings accounts or certificates of deposit.
Similarly, borrowers can seek loans from alternatives to traditional lenders, such as banks. They may be seeking a lower interest rate, for example.
Overall, peer to peer lending is less safe than other forms of lending.
Peer to peer lending includes many of the same risks as traditional loans.
Any lenders using a P2P platform have to consider credit risk (the possibility that the borrower will default on the loan or otherwise fail to meet their obligations). This is similar to the risk banks assess and accept, as not all their borrowers can/will fulfill the contract’s obligations.
However, it must be noted that P2P lending platforms have higher default rates.
Specifics vary by location, platform, and other factors. One of the worst examples is China, where P2P lending platforms have a horrifying default rate of 87.2%, as of 2019.
In the US, default rates of above 10% on P2P lending platforms are not unheard of. Most platforms have a default rate of between 2% and 7%.
While the lower end of that range is not much worse than it is for traditional lending, one should be careful in their vetting of P2P lending platforms they are interested in and the borrowers on them.
As a point of comparison, delinquency rates (90 days or more past due) for all consumer loans from commercial banks have been below 2.50% since Q4 of 2013 and seldom even approach 5%.
P2P lending started in 2005 and has since become more popular. Many investors use it as a small portion of their portfolios. The idea is simple; using technology to connect two parties.
While P2P lending has some advantages, there are some significant risks too. To avoid loss, it’s important for users to carefully vet both the platform and the borrower.
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