Cashay logo

Empowering your money

Peer-to-peer lending: The full breakdown

At a glance:

  • What is peer-to-peer lending? Here are the basics

  • How does peer-to-peer lending work?

  • Peer-to-peer lending services

  • Advantages and disadvantages of peer-to-peer lending

  • Summary of peer-to-peer lending

If the idea of total strangers loaning you money outside of the traditional bank setting strikes you as strange, it's really not. It's a form of business. It's called peer-to-peer lending.

Also known as person-to-person lending, peer lending, P2P, or social lending, it is an alternative to traditional financial institutions. But like traditional lending, it comes with its own set of issues.

What is peer-to-peer lending? Here are the basics

Peer-to-peer (P2P) lending is the lending of money that occurs directly between parties without the involvement of a traditional financial institution. As such, it is very old and rather common. Its modern form was made possible by the Internet, and it has evolved to become a business activity of its own, with a profit motive.

Its modern form

Peer-to-peer lending as we know it arose when many individuals (and some businesses) found themselves unable to get credit from banks and other financial institutions during the financial downturn that began in 2007. Using the Internet, some responded to the demand by setting up sites through which borrowers and lenders could work together to make loans.

Why do people use it?

People borrow money from peers for the same reasons that they borrow it from traditional institutions: to get mortgages, business loans, or education loans; to consolidate debts, etc. Lenders lend for a variety of reasons, such as the chance to get high earnings. Borrowers and lenders aren't just individuals; there are businesses and institutional investors that engage in P2P as well.

The typical amount of money borrowed varies greatly, but most loans are very small.

The lack of a middleman (intermediary) means that there is lower overhead than would be with a traditional financial institution. There are fewer servicing costs and other expenses.

Roles of the Internet and social media

The Internet has made it easier to match lenders and borrowers. Many sites have sprung up to cater to the supply and demand for these private loans.

Some peer lending takes advantage of social networks, whether online or not, with the idea that familiarity can lower the risk of defaulting on a loan. Loans made to family and friends are less likely to be done through a professional intermediary, and they have more wiggle room when it comes to interest rates and repayment terms.

How does peer-to-peer lending work?

Peer-to-peer lending works by bringing borrowers and lenders together to set the terms of a loan and execute it. Most often, it occurs on an online lending site set up for that purpose. The site acts as a broker that facilitates the transaction.

Unlike a brick-and-mortar institution that owns the loan, an online lending site can allow a single loan to be shared by many investors.

Having an official location, whether online or physical, to do the business provides some accountability and regulation.

In a nutshell

Usually, lenders and borrowers meet on a site that lists loan opportunities. Borrowers must first list their requests and provide information about the loans, about their creditworthiness, and about collateral, if any. The broker then evaluates the borrowers' creditworthiness and provides a rating for it. Potential lenders then view the listings and ratings and evaluate the requests.

Lenders establish criteria for what they want to invest in, such as dollar amount and various other loan specifics. They then view available loans that match their criteria, and they decide whether and how much to invest.

Once a loan is complete, the borrowers begin making monthly payments and lenders receive a portion of those payments. The lender does not necessarily service the loan, however; the site itself may do that, or a third-party site may instead.

On some sites, there is an auction-like process in which lenders compete to set the lowest interest rate; the one who "wins" gets to give the loan.

The range of interest rates can vary greatly depending on the creditworthiness of the borrower.

The secondary market

Just as with home mortgage loans, loans originated via peer lending might be sold to other investors.

How is it regulated?

In the United States, loans made on P2P lending sites must be registered with the Securities and Exchange Commission, the federal government's regulator of investments. This requirement came in response to unusually high default rates on loans in years past, and exists to provide some oversight over the whole process.

Soliciting investments from the public, which is the model that P2P sites use, is considered a sale of securities, and so a site must be registered as a broker-dealer if it is to engage in this lending.

Peer-to-peer lending services

What services are offered?

Peer-to-peer lending services are fairly straightforward. There is loan origination, which involves matching lenders and borrowers, writing the loans, and actually disbursing the money.

There is also loan servicing, which involves creating payment schedules, collecting payments, transferring payments to lenders, and handling paperwork. Loan servicing isn't always offered by the same companies that offer loan origination. Instead, third parties may take care of this.

Loans may be direct or indirect

Direct lending means that one lender loans money to one specific borrower; this model exposes the lender to the risk that the borrower will default. Indirect lending means that a lender lends to several borrowers or that several lenders lend to a single borrower.

The purpose of both types of indirect lending is the same—to cut the risk to the lender(s) if the borrower defaults on the loan. Not only does the spreading of the money accomplish this, but so does the fact that there are numerous other loans outstanding.

Loans may be secured or unsecured

A secured loan is one that is backed by some form of collateral that the borrower puts up; if the borrower fails to pay back the loan, he or she loses the collateral. Collateral might be a piece of equipment that was purchased with the loan, for example, or it might be something unrelated.

An unsecured loan does not have collateral; rather, the lender lends money based on the borrower's credit rating. As such, an unsecured loan carries more risk with it.

Advantages and disadvantages of peer-to-peer lending

Many of the pros and cons of peer-to-peer (P2P) lending arise from its directness and its lack of an intermediary. With no traditional financial institution to handle the lending process, there is far less expense for customer service, marketing, employees, rent, and other costs.

This results in lower overhead costs for the borrowers and lenders. It should be noted that although there are no financial intermediaries per se, the P2P companies actually perform many of these same tasks themselves.

The pros

Higher potential earnings. Lenders can earn higher rates because there is little or no overhead that would otherwise take a bite out of earnings.

Lower interest rates for borrowers. Peer-to-peer lending often involves lower interest rates than those charged by traditional institutions.

It's attractive to those with poor credit. Some would-be borrowers don't qualify for traditional loans because their credit is poor or nonexistent. A P2P lending platform is therefore attractive to them. However, this access does not come without challenges; for example, those with bad credit may have to pay high interest rates on their loans.

Faster turnaround. Getting a loan approved and money transferred takes less time because there is less administration and thus less bureaucracy.

The cons

Defaults. Because P2P attracts borrowers with low credit, and because low credit is correlated with defaults, there is the risk of default to consider. Internet P2P companies have begun to address the danger of default by declining those with low credit scores, by requiring borrowers to pay into a compensation fund that works similar to insurance, or by putting up collateral … or by using a combination of these means.

Insufficient information about the borrowing requests. Traditional financial institutions have access to information about borrowers and their loan requests. They may even have research departments or pay for access to research about them. P2P companies have comparably less than this; often, the loan information is limited to the borrower's description of it.

Insufficient regulation. While it's not the Wild West in most cases, P2P is less regulated than traditional institutions. This can open it up to loan sharking and to lending based on illegal criteria, among other things. It also contributes to the rate of default.

Fewer services. Though this can cut overhead costs, some see a disadvantage in having barebones services.

Reintermediation. The benefits of being without a middleman can begin to die out as P2P companies grow and spend money on administration, product information, legal compliance, and other traditional costs. In other words, P2P lenders risk becoming the one thing they broke away from.

Summary of peer-to-peer lending

Is peer-to-peer lending attractive to you, perhaps because you have bad credit or because you are looking for a higher return on your investment than you are currently getting? P2P is attractive to both borrowers and lenders and can serve them both.

Being a new version of an old practice, it has a number of wrinkles to iron out, not the least of which are complying with regulations and offering services that both borrowers and lenders will want. Ironing out these wrinkles may add to the cost of P2P and make it less attractive.

It remains to be seen how peer-to-peer lending will navigate its challenges and become its own business model, and whether it can stay distinct enough that its advantages can flourish.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Debt section

Read more personal finance information, news, and tips on Cashay

Follow Cashay on Instagram, Twitter, and Facebook