Understanding Peer-to-Peer Lending And How It Works

Read Time: 6 minutes

When you need to borrow money for your home, business, or another reason, your funding sources aren’t limited to banks and other common lenders.

Alternatively, you can explore peer-to-peer (P2P) lending, a type of crowdfunding that involves borrowing money from individuals or special lenders instead of banks and other traditional lending institutions.

This can enable you to receive funds more quickly and with less red tape involved.

But peer-to-peer lending has its risks and disadvantages, too. Do your due diligence and find out how P2P lending works, what the funds can be used for, worthy borrower prospects, and where to find peer-to-peer lenders. 

Peer-to-peer lending explained

P2P lending connects borrowers directly with individual lenders, using an online platform, without having to go through a traditional financial institution or bank. 

Andrew Lokenauth, a personal finance expert and owner of BeFluentInFinance.com, explains how peer-to-peer lending works.

“You create an account on a P2P lending platform and fill out a loan application with personal and financial details. The platform evaluates your credit risk using factors like income, credit score, and existing debt,” he says.

“Your loan request is then listed on the platform for different lenders to browse through and fund if they choose.”

If approved, your loan is funded by one or more small individual lenders who each lend a portion of the total loan amount, which spreads out the lending risk involved. Then, you receive your loan amount minus any fees.

The interest rate you are charged will depend on your credit score, loan amount, repayment terms, and other factors. Your loan repayments are made directly to the P2P platform, which distributes these funds to your lender(s).

Popular peer-to-peer lending platforms today include LendingClub, SoFi, Prosper, Upstart, Funding Circle, Lending Point, Happy Money, and Avant. 

Peer-to-peer lending uses

Borrowers often turn to peer-to-peer lenders for many funding purposes, including:

  • Mortgages – P2P lending can fund home loans, allowing borrowers to purchase a property without going through banks, “although these loans often have shorter terms – often five years or less – and higher interest rates compared to traditional mortgages,” says Dennis Shishikov, head of growth at Awning and an adjunct professor of economics at City University of New York.
  • Down payments and closing costs on a home purchase.
  • Consolidating debt – “Borrowers can often take out P2P loans at lower interest rates to consolidate higher-interest credit card debt,” explains Lokenauth.
  • Business funding – Small businesses and startups may find it easier to borrow via peer-to-peer platforms than banks.
  • Major purchases – Big-ticket items like vacations, car repairs, or medical procedures can be funded via P2P loans, as can tuition/education costs. 
  • Investments – “Some folks use these loans to invest in stocks, startups, or even other real estate,” Shirshikov continues.

On the other side of the equation, those interested in becoming a P2P lender join these online platforms to ideally earn attractive investment returns on the money they lend to borrowers, “which can offer more control and sometimes better yields than investing in funds,” Lokenauth adds.

Good borrower candidates for peer-to-peer lending

Worthy prospects for considering a P2P loan include those with good credit scores, steady earnings, and job security, first-time borrowers who are unable to get approved for bank loans, people seeking to refinance debt at lower rates, those who prefer smaller short-term loans, and entrepreneurs and small businesses unable to qualify for bank loans.

“Perhaps you have a shorter credit history, a unique financial situation, or you simply need money quickly, in which case a peer-to-peer loan could be ideal,” says Shirshikov.

But if you have a poor credit history and a credit score below 640, have high existing debt or limited income, and seek larger loan amounts (typically above $40,000), you may not get approved for a P2P loan, per Lokenauth.

Pros and cons of peer-to-peer lending

  1. Keith Baker, a real estate professor at North Lake Campus of Dallas College in Irving, Texas, says P2P lending offers a few advantages over other types of financing.

“The process is done completely on an online platform and, therefore, seems to deliver more convenient and rapid loan approval thanks to the completely automated system for review and application approval. You may be able to get funds dispersed in as little as one day after approval,” he says.

“There are also less stringent eligibility requirements than traditional bank loans. Borrowers with little or no credit or who are still developing a credit history might be more likely to get approved.”

But there are downsides associated with P2P lending, too. 

“These include higher interest rates for riskier borrowers, the possibility of borrower default leading to investor losses, potentially lower maximum loan amounts, and less regulatory oversight compared to traditional banks,” cautions Jeff Rose, a certified financial planner and founder of GoodFinancialCents.com. 

That first drawback is a particularly painful one. Consider that P2P loans are unsecured, which means they don’t require collateral (such as your home) to secure the loan.

The good news here is that you aren’t at risk of losing your home, car, or other collateral if you default, but the bad news is that the lender will charge a higher interest rate to help offset this risk.

“Expect to pay lower interest rates than credit cards or payday loans but higher rates than traditional bank loans,” says Lokenauth.

Also, while many P2P platforms boast a low-fee structure, “your loan might come with additional fees and higher charges than traditional loans – such as an origination fee of 8% of your loan amount,” adds Baker.

“And there can be a feeling of poor support if you need to restructure your loan because of a job loss or other hardship, as most P2P platforms usually just turn over delinquent loans to collection agencies. Banks, on the other hand, might work with a borrower to create a repayment plan.”

Furthermore, many P2P platforms don’t offer mortgage loans, so it could be challenging to find a peer-to-peer lender willing to fund your residential purchase.

“Most current P2P platforms would rather handle home equity and home improvement loans on properties that already have a mortgage that was made when the home was purchased,” adds Baker.

Lastly, be aware that there is always a slight chance that a P2P platform may fail or be consolidated.

“There is a risk of any given platform collapsing as we see inevitable consolidation in this industry and more careful scrutiny of this business methodology going forward through the next correction in the finance business,” Baker points out.

What to consider before pursuing peer-to-peer lending

it’s crucial to research P2P platforms thoroughly before choosing one and scrutinizing the interest rate, terms, and fine print on a peer-to-peer loan prior to committing.

“Only borrow what you can comfortably repay, and be aware of any fees involved,” advises Lokenauth.

“I would start with a smaller loan amount request until you establish a good payment history, and I wouldn’t take out multiple P2P loans at the same time. Also, make sure you have a repayment plan to turn to in case your income is disrupted.”

As with any consumer product, do your homework and ensure the platform is reputable.

“Always be on the lookout for phishing scams as this is a slightly less regulated industry,” Baker warns.

Erik J. Martin

Erik J. Martin is a Chicago area-based freelance writer and public relations expert whose articles have been featured in AARP The Magazine, Reader’s Digest, The Costco Connection, Bankrate, Forbes Advisor, The Chicago Tribune, and other publications. He often writes on topics related to real estate, personal finance, technology, health care, insurance, and entertainment. He also publishes several blogs, including Martinspiration.com and Cineversegroup.com, and hosts the Cineversary podcast (Cineversary.com).

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