What Is P2P Lending? (With Benefits and Examples)

P2P lending, or peer-to-peer lending, is a financial lending process that connects lenders or investors with individuals who need funds for business ventures. It's also called social lending or crowdlending, as it creates a business relationship between two professionals or a professional and a third-party service, rather than individuals and banks. By learning more information about P2P lending, you can better determine whether this loan method is right for you. In this article, we explore what P2P lending is, explain its common benefits versus potential disadvantages, describe how it works and provide examples of situations that may require it.

What is P2P lending?

P2P lending involves connecting business professionals who require loans with other individuals or companies that can supply them through an online platform. Financial institutions like banks or credit unions typically provide loans for borrowers instead. P2P lending allows borrowers to bypass this system entirely, which can often help them get funds more quickly. This also allows lenders to make a return on an investment in another individual, as they can accumulate cash from an interest rate. Many online platforms have security features to protect the financial and personal information of both borrowers and lenders.

Related: Learn About Being a Loan Processor

Benefits of P2P lending

There are many benefits to P2P lending for both lenders and borrowers , including:

• Opportunity to build wealth: As P2P lenders may not receive funds back from borrowers who default on their contracts, they often set interest rates at higher amounts than average rates from a different type of institution. This allows lenders to increase their income after making an investment.

• More options for borrowers looking for cash: Some borrowers may be unqualified or unable to secure loans from regular financial institutions. P2P lenders can have unique requirements, which can provide borrowers with more loan opportunities.

• More options for interest rates: Lenders often base interest rates entirely on a client's credit score, rather than include the value of their assets. As a result, they may have more low-cost options for interest rates than other types of financial institutions.

• Prequalification options for borrowers: Many lending platforms provide prequalification for loans quickly and easily by instructing borrowers to complete an initial questionnaire. In their results, borrowers can view their qualifications for loan terms, sizes and interest rates.

• Opportunity to build credit: If a borrower aims to increase their credit score, getting a personal loan allows the borrower to merge debts for fewer monthly payments. By streamlining this process, they may be able to make more regular, on-time payments to receive more loan options in the future.

Related: Top 8 Reasons To Become a Loan Officer (Plus Definition)

Disadvantages of P2P lending

Some disadvantages or risks involved in P2P lending may include :

Less protection

P2P lenders rarely receive insurance policies, as the Consumer Financial Protection Bureau (CFPB) and similar state agencies don't regulate using the same standards as a traditional lending service. As a result, P2P lenders may not be able to protect their assets from the effects of a defaulted loan contract. To mitigate this risk, it's often helpful to conduct in-depth research on any borrower who applies for a loan. It's also important to budget a P2P lending company effectively to ensure it can withstand any larger financial losses.

More credit risk

Some individuals who apply for loans from a P2P lending service can have more low credit scores, as traditional bank systems may not qualify them for a loan according to their guidelines. As a result, these borrowers may present more financial risk, meaning they may miss payment deadlines and P2P lenders may not receive funds back from a loan according to the terms of an initial contract. Consider developing an in-depth contract with stipulations on defaulted payments and conducting additional research on each borrower. For example, you can research their available assets or previous repayment history.

Related: What Are Collateralized Loan Obligations (CLOs)?

More lending fees

Online P2P platforms typically charge borrowers a fee for the money and agreement exchanges. Depending on an individual loan contract, borrowers may pay an upfront fee or make payments every month for a certain time period. To ensure lenders and borrowers both understand the terms of a loan payment plan, it may be helpful to discuss these expectations in a dedicated meeting. If you're a borrower, consider reviewing a fee payment plan and asking lenders any clarification questions you may have.

How does P2P lending work?

P2P loans can either conduct a secured or unsecured lending process. A secured lending process involves using a borrower's assets as collateral if they default on a loan contract. Unsecured loans don't require stipulation and are typically more common in P2P lending, as borrowers may not own enough required assets to serve as collateral. Here are the common steps of both a secured and unsecured P2P lending process:

1. The borrower fills out an application. Then, the online lending platform reviews the application and determines its parameters, allowing a borrower to view their qualification data.

2. The borrower submits the application. Afterward, the platform assesses the borrower and provides a credit rating based on their credit score. The P2P lending company uses this information to determine if the borrower is worthy of investment, then provides interest rate options.

3. The lender submits their terms. Upon reviewing the borrower's application, a lender composes a contract with their loan terms, including its amount, their preferred interest rate and the amortization period.

4. The borrower chooses a lender. If they receive multiple plan options for a single loan transaction, the borrow selects which plan best suits their needs.

5. The borrower receives money. After signing the loan contract, the borrower receives the loan money through an electric wire transfer within a certain timeframe determined by the lender.

6. The borrower makes payments. After receiving funds, borrowers are typically responsible for submitting payments according to a predetermined schedule. Once they finish these payments and clear their debt, the lender can verify their ability to complete the loan contract.

Related: What Does Amortization Mean?

Examples of P2P lending

There are many reasons individuals may apply for a P2P personal loan. Here are some common examples:

• Home improvement: Renovating a kitchen, bathroom or another room can have large costs that require loans to pay these amounts fully. P2P lending gives borrowers the opportunity to secure funding quickly for projects, allowing them to streamline the renovation process.

• Debt consolidation: This involves merging multiple debts into one payment plan with a single interest rate. If individuals have multiple debts, they can use a P2P lending service to combine these plans into one contract and secure the money to pay them on a set schedule.

• Large purchases: P2P lending can also help borrowers secure funds for large purchases, like cars, houses or long-term child care services. For example, they may receive a more low-cost interest rate for vehicle financing than a car dealership or mortgage loan officer.

• Medical bills: As medical bills can incur unexpectedly, some borrowers may require more funds to pay costs up-front for fast procedures. P2P lending can help provide borrowers with the money required to pay for the bills while giving them more time to save up the money to pay it back.