Blog Invest How Does Peer to Peer Lending Work?

How Does Peer to Peer Lending Work?

date October 1, 2020 time 6 min read 824 views

Peer-to-peer (P2P) lending enables borrowers to get loans directly from individual investors entirely online. This removes traditional banks and other lending institutions’ overhead costs to offer lower rates to borrowers and better returns to investors/lenders.

Why is it that when you think about getting a loan your first thought is the bank? Sure, banks are trustworthy, but darn they have some strict terms.

Bank loans came about as a solution to a lack of trust and information between individual lenders and investors in a growing economy. Because banks have gobs of money in their vault, they can mitigate any defaults and pursue delinquent loans with the full force of the law.

But in an era where banks are getting stingier about giving out loans and interest rates are sky-high, people are looking at other places to get a loan. 

That’s why P2P lending was created as an alternative to the traditional system for the modern era. 

How does peer to peer lending work
How does peer to peer lending work (source: blog.fundingsocieties.com)

How peer to peer lending works

Traditional peer to peer lending 

Traditional P2P lending involves a borrower, lender, and a lending platform. The lending platform runs the entire borrowing process, from the loan application to the disbursement of the loan and loan repayment. 

For borrowers

  1. You determine a loan amount and state the loan purpose. 
  2. The platform evaluates your creditworthiness and assigns an interest rate. 
  3. You post the loan on the platform. 
  4. You receive the loan and begin repayment.

For investors

  1. You deposit funds online or link a bank account/debit card.
  2. You check the lending site for loans with an appropriate interest rate/default risk.
  3. You fund the loan and begin receiving interest.

Risks

As with traditional loans from a bank, the risk of default is always reasonably high — especially if there’s no collateral to fall back on. In a traditional P2P lending model, the risk is placed entirely on the investor. If the borrower defaults, the investor might lose part of or the entire investment. Platforms will usually work hard to make sure they assess borrower risk accurately so there are no unpleasant surprises.

Crowdlending

Crowdlending is sometimes used as another name for peer-to-peer lending or marketplace lending. In crowdfunding, investors co-finance projects by lending money to borrowers in return for interest.

For investors

On most crowdlending platforms, investors deposit money into a pool of funds and borrowers borrow from this pool via the P2P platform. These loans can be collateral-backed or not and interest rates for borrowers will vary accordingly. Usually rates are more steady since risk is mitigated by the pool.

For borrowers

Conversely, on most platforms one large borrower asks for a loan (almost always collateral-backed) and investors take out small chunks. Interest is paid back to the platform and then distributed among the investors.

Risk

In crowdlending, risk is split between the P2P platform and borrowers. That means interest rates for investors are usually lower (or subject to change) to mitigate any losses from borrowers.

Collateral-backed lending

In collateral-backed lending, the loan is secured by an asset such as equipment or machinery for business loans (this is usually crowdlending) or even cryptocurrency (for individual loans).

Traditionally, when a bank asks for collateral they’ll take something like your car or house. But in the case of P2P lending, more platforms are accepting cryptocurrency as collateral because of its high liquidity.  

For investors

Usually the process is similar to non-collateralized loans. There’s much less risk assessment required in collateral-backed lending since you know the money’s there. However, this means you can’t access the 35% interest rates platforms slap onto high-risk loans.

For borrowers

You benefit because you usually pay a flat interest rate and rarely need to go through a credit assessment. Credit assessments can sometimes impact your credit score. 

Risk

In collateral-backed P2P lending, the risk is placed on the borrower. If you default, collateral is sold by the P2P platform to recover any losses incurred by the investor. To the investor, collateral-backed loans promise financial security.

Loan Origination (LO)

LO lending works through four parties:

  • The lender
  • The P2P lending platform
  • The loan originator
  • The borrower

The loan originator is usually a non-bank lending institution such as a mortgage company. Loan originators attract borrowers and determine if they qualify for the loans.

This allows the P2P lending platform to focus on bringing in lenders/investors. Instead of choosing between individual borrowers, as an investor you choose which loan origination platform you think is trustworthy. Platforms are usually given ratings similar to the credit assessments in traditional P2P lending.

Risks

In LO lending risk is on the Loan Originator. However, this model’s transparency is not as high as in traditional P2P lending. The investors are also at risk of losing their funds if the loan originator goes bankrupt though this is often much less likely than a borrower default.

Peer-to-peer lending requirements

For borrowers

Qualifying for an unsecured peer-to-peer loan still often relies heavily (though not entirely) on your credit score. In order to get a low rate you’ll want your FICO score to be in the ‘fair’ category (around 600+). There are, however, loan options available to sub 600 scores on many platforms if you’re willing to let rates creep up. 

Some P2P lending sites will conduct a ‘soft inquiry’ into your credit history which does not show up on your credit score. However, if your credit score is low and you’ve been rejected for loans in the past, then the P2P lender might take a ‘hard inquiry’ into your credit history. These types of inquiries might appear on your credit history and make your score lower. 

A good rule of thumb: work on getting your credit score higher first if you want to take out an unsecured loan.

And if credit scores a dealbreaker for you, then you may want to give collateral-backed loans a try.

For investors

P2P platforms are rarely picky about their investors. Usually the only limits on what kind of platform you can invest with will be imposed by your bank or local government.

How do peer-to-peer lenders make money?

P2P platforms generate revenue through fees to borrowers and investors. Borrowers are usually charged service fees and late payment fees. Service fees are used by the platform to cover the costs of reviewing and listing the loan and providing access to its investors.

On the investor side, the platform will usually take a percentage of the loan’s interest. For example, a platform may deduct a 1% fee of each repayment amount. So, if a borrower pays $200 in interest on a loan, $2 belongs to the platform, then the rest is passed on to investors. 

Be sure to compare different P2P lenders and their fees to know what to expect.

Can you make money with peer to peer lending?

In short: Yes you can. However, making a profit from peer-to-peer lending (or most investment ventures) is not a quick task — investing takes time and depends on how much money you’re willing to put in and allow to grow.

Peer-to-peer lending isn’t a substitute for your primary source of income, but it’s an excellent form of passive income. Many peer-to-peer investors report an annual investment return greater than 10%.

Can you make money with peer to peer lending
Can you make money with peer-to-peer lending? Absolutely! Many investors claim average returns of roughly 10% (source: p2pmarketdata.com)

Steady returns are nice but only if your borrower doesn’t default. Always make sure to fully assess the risks on all P2P platforms before investing.

Try collateral-backed P2P lending with MyConstant, get rates as high as 11%

At MyConstant, all lending is backed by highly-liquid crypto collateral. Our easy P2P lending requirements give borrowers a quick way to get loans against your crypto assets without any credit checks. A US-registered asset custodian keeps all collateral deposited on our platform in a mixture of hot and cold wallets.

MyConstant offers loans backed with liquid cryptocurrency — giving you peace of mind.

For the investors, we offer just about everything. From crypto-backed individual loans, crypto credit, and our crowdlending pool. Our investment options offer interest rates up to 11% APR.

Feeling intrigued by P2P lending? Come see you how you could be doing more with your money today.

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George Schooling

George Schooling

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