Peer-to-peer lending (P2PL) is a form of money lending whereby unrelated individuals, known as “peers,” lend money to one another. This exchange of money doesn’t go through a traditional third party such as a bank but rather an online P2PL company. The loans are usually unsecured personal loans.
How peer-to-peer lending works
The P2PL company acts as a mediator between lenders and borrowers. The lender typically deposits the money that s/he wants to lend out and fills out a form specifying the type of borrower they want to lend their money to, repayment terms, etc. The riskier the borrower, the higher the interest the lender receives.
When a borrower wants to take a loan s/he fills out a form on the P2PL company’s website. If the application is accepted the borrower is matched with a lender by the P2PL company. On some sites, lenders can take part in an auction whereby they bid to lend their money to a potential borrower. They specify how much they are willing to lend out and the interest rate that they will attach to the loan.
Money that belongs to the lenders and money that belongs to the P2PL company is handled separately so that there’s no confusion. However, some P2PL companies also lend out money to borrowers.
Pros of peer-to-peer lending
The biggest advantage of P2PL for borrowers is that interest rates are much lower than bank interest rates. As such you have a smaller financial burden to bear when paying back the loan. The main advantage for lenders is that you can make more money in the form of interest from P2PL than you would if you were to place that money in a savings account in a bank or other investments.
In many cases, P2PL gives borrowers access to loans that they might not have been able to get from banks and other financial institutions due to bad credit, not having security, or any other reasons.
Another advantage of P2PL for both borrowers and lenders is that interest rates are not very volatile. So the chances of a borrower paying back considerably more than what they borrowed, or a lender getting back significantly less than what they lent out are quite low.
Cons of peer-to-peer lending
Everything has its cons and P2PL is no different. Although there’s the potential to make more money from it, it’s risky for lenders as there’s little assurance that they will get all their money back plus the interest they are owed.
In some cases, the interest rates may be higher than other financial institutions. Higher interest rates are given to compensate a lender for the risk they’re taking by lending out their money with little assurance of repayment.
It’s important to be aware of the risks of P2PL before you dive in. The potential returns are high but so are the potential risks. Always go through the terms of the P2PL site before signing up and it’s usually best to not put all your money into the P2PL model. If you happen across a very risky borrower you could lose all your money.