Peer-to-peer (P2P) lending, also known as “social lending”, allows individuals to borrow directly from each other. Just as eBay eliminated the middleman between buyers and sellers, so did P2P lending companies such as Prosper eliminate financial intermediaries such as banks and credit cooperatives.
P2P lending improves the returns of individuals who provide funds and reduces the interest rates of those who use funds, but it also requires them to spend more time and energy, and brings more risks. Read on to learn more about this modern loan type.
Social lending background
P2P lending is the product of important business, technological and social trends, including:
- A new generation of so-called “freeformers” who combine personal freedom with social radicalism. Freeformers want to control their work and leisure. Rather than working in a company for 35 years, they prefer short-term cooperation in a network of various projects. Freeformers are highly suspicious of large institutions; they believe in people, not banks.
- Disintermediation of almost everything. Technological changes, globalization and other international trends continue to reduce the number, scale and role of commercial intermediates in many industry sectors.
- Promote the dissemination of “large-scale collaboration” network technology. These new tools allow individuals to collaborate online in large groups to achieve common goals (e.g. social networking sites such as eBay and Facebook).
- Develop small loans to individuals with few assets in developing countries. Loan entities with a sense of community and society, such as credit cooperatives, have existed for a long time. But microfinance promoted the idea of providing small loans to individuals to achieve social goals. (For more information, please read: Microfinance: what it is and how to participate.)
There are many P2P online lending outlets
Like most types of financing, P2P lending is also diverse.
In addition, the legal issues surrounding the P2P lending business, especially in the United States, have not been resolved at all. Questions still exist about what type of entity the P2P lender is and which regulatory regime is applicable. Because of these concerns, foreign P2P lenders’ operations in the United States sometimes go far beyond their original business model.
With these considerations in mind, the following is how P2P lending works in a typical scenario:
You register and become a member on the P2P lender’s website, and the lender acts as an intermediary (responsible for record keeping, transferring funds between members, etc.). Loan companies earn income through fees charged to lenders and borrowers.
Before you can borrow, the P2P lender will perform multiple checks (personal, employment, credit, etc.). The standards are relatively strict, and those with high credit risk cannot be borrowed. After accepting, you have two or more choices.
- The P2P lender will assign you to one of four or five risk categories, and you can borrow at the prevailing interest rate for your risk category on a specific date; or
- You can auction your loan to members who have funds to lend. The lender/bidder will see the relevant information you provide on the P2P lender website: why you need the money, your financial history, your personal story, and even more personal information, such as photos or poems you wrote . You set an initial interest rate for the loan and accept the bid; if the loan is fully funded, the lender can lower the interest rate they are willing to charge to win the right to fund your business. (For related reading, see: P2P lending websites: How safe are they for borrowers?)
As a lender, in addition to bidding for personal loans, you can also choose to let the P2P company spread your funds among multiple borrowers. You decide the risk category of the loan; the greater the risk in your loan portfolio, the higher the return, but the greater the probability of default.
Pros and cons
The main benefits of P2P lending to individuals are:
- The lender can enjoy a return several percentage points higher than the bank’s CD; compared with the interest rate of the bank or credit union, the borrower enjoys a similar cost advantage.
- Many people like to know who they borrow money from and why they need it. This not only brings them personal satisfaction, but they can also choose borrowers who they think will repay their loans on time and in full.
- Loans have a charitable side. If the financial situation of the potential borrower is not good, but the story to be told is sympathetic, the lender can willingly choose to forego higher returns and take greater risks to fund the loan.
- There can be a real sense of community on the P2P lender site. Forums are often very active, and users are eager to exchange information about lending experience. There was a heated debate on the proposed changes to P2P lenders’ policies.
- Some people just hate banks and will avoid using them at all costs.
Naturally there is a disadvantage:
- Many borrowers are excluded because they do not have good credit. (For related reading, please see: What is a good credit score?)
- The lenders are at risk of default and their funds (with some exceptions) are not insured. The success of P2P lenders in limiting loan losses varies by lender and time. Lenders can persuade them to provide a bad loan with a good crying story.
- Compared to going into a bank or credit cooperative, P2P loans require more work, especially if the loan is raised through auctions. The loan selection and bidding process may require a degree of financial complexity that many people do not possess.
- Although the return of the lender may be higher than the return of the certificate of deposit, over time, it is uncertain whether they will be higher than the publicly traded index funds, which require relatively little work to buy and hold.
- Not everyone wants to publish their financial stories on the Internet; for those who have a certain sense of personal privacy, big banks have their benefits.
- Because this is such a new industry, there will inevitably be consolidation of lending institutions, interface/management changes, and changes in lending practices themselves. This may be greater than the burden and risk that a disciplined investor is willing to allow.
Despite its shortcomings, P2P lending is gaining traction and seems certain to become more popular. There are P2P lenders in many countries, including Italy, the Netherlands, China, and Japan, and they operate in many other countries.