Peer to Peer Lending - Explained
What is Peer to Peer Lending?
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Table of ContentsWhat is Peer-To-Peer Lending?How Does Peer-To-Peer Lending Work?List of peer-to-peer lending sponsors
What is Peer-To-Peer Lending?
Peer to peer lending is a way of financing debt that allows lenders and borrowers transact without using an intermediary, which often include banks. While P2P makes it possible for borrowers to get funds from lenders, the parties involved will have to incur more risk, effort and even time than conventional banking systems. It is also referred to as social or crowdlending.
How Does Peer-To-Peer Lending Work?
The conventional method of getting a loan involves individuals and even businesses applying for funds through a financial entity. The financial institutions would then be responsible for conducting background checks to determine if the individuals or small businesses were eligible. If they are, the bank will then determine the interest rates before it dishes out the funds. People that would be rejected from this check or those that want to avoid high interest rates can opt for alternative debt finance- i.e. peer to peer lending. Peer-to-peer lending is a method of financing debt where those without funds borrow from those who have funds to invest. This type of funding allows the two participants to do this without using banks as financial intermediaries. It also extends credit to those that would otherwise not get it through the conventional financial entities. P2P lending occurs when individual lenders can directly loan borrowers by using an online P2P platform. How does peer-to-peer lending work? You are probably wondering. Well, borrowers in peer-to-peer lending accept to receive loans from other individual investors at a certain interest rate. This is achieved on a peer-to-peer online platform where the profile of the borrower is displayed. Investors are then given access to such profiles to establish whether they would want to lend their money to such a borrower. Borrowers do not necessarily receive the full amount requested but they can get portions of what they asked from other lenders. A loan may have multiple sources in peer-to-peer lending and the monthly repayment should cater to each individual sources. The main aim of P2P platforms is to link up borrowers and lenders while also offering an irresistible interest rate. For those willing to lend their funds, the money their investment generates income by offering interest. The interest rates that investors get from P2P platforms is higher than what they can get in alternative investment vehicles such as CDs and savings account. For example, the lenders get better returns than investing in the stock market through the monthly payments and interest from the funds they lend. Borrowers, on the other hand, also benefit since they get access to loans, which they would not have received from banks. These loans also have a better interest rate than the ones that they could have received from a financial institution. P2P lending allows people and even small businesses to take unsecured student loans, commercial and real estate loans, payday loans among others. Like in conventional banking, any lender that is not comfortable with offering an unsecured loan may ultimately decide to take some collateral, which may include jewelry, fine art or watches. Lending in a P2P platform is not without risk as P2P borrowers may also default on the given loan. It is worth noting that the government does not guarantee P2P investments and this is why lenders can choose who they wish to fund. This means that one lender can diversify their investment over many borrowers. A P2P intermediary is any platform that aims to connect lenders and borrowers without involving a third party. Those that wish to get a personal or business loan approved can simply file an application to join the P2P platform that will then asses their credit risk, give them a credit rating and fix a suitable interest rates to their profiles. Monthly repayments will also be made through the platform, which processes and ensures lenders receive their invested sum. Lending club, the largest P2P lender in the world, offers individual loans ranging from $1000 to $35000. It also offers $15000 to $350000 to companies over a fixed period of 36 to 60 months. The interest rate charged by the platform varies from 5.32% to 30.99% but this depends on the creditworthiness of the applicant and the loan grade. A fee of 1% is also charged to investors for any payment that will be received within 15 days of the agreed period. The person borrowing the funds will also have to fork out an origination fee that will range from 1% to 5% depending on the credit grade assigned by the platform. Any payment that bounces back will be charged $15 while borrowers that default for more than 15 days get a 5% fee or $15, whichever is higher. Since each state in the US has its own financial regulations, not all states allow P2P platforms to carry out their operations in their jurisdiction. States such as Iowa, North Carolina and even New Mexico, for example, have ensured that P2P lending is disallowed. Both the investors and the borrowers should ensure that P2P lending is legal in their state before registering on a P2P platform. The main objective with P2P lending is to ensure that investors can lend their cash at higher interest rates than saving. At the same time, it also aims at allowing borrowers to access funds at relatively lower rates than banks by using online platforms where both participants register. Of course some form of due diligence has to be conducted before any lending and borrowing can take place. Since P2P platforms are now regarded as non-banking financial institutions, they are regulated by the RBI. The advent of peer-to-peer lending has had a couple of effects in the financial services industry. First, it has created new competition in the industry for investment vehicles and loans. Also it has improved access to financial services to more consumers. Retail investors that lend money to others can now expect to get a return of atleast 4 to 8% of the amount that they invest. The P2P lending platforms also offer a high sense of transparency, which makes it easy for the retail investors to assess the performance of their lending against the expectations. These platforms follow a strict code for risk assessment that is consistent with the best practices of conventional lenders. It is also worth noting that P2P lending does not develop systemic risk and they can thus deal with a downturn in a better way. For investors to lose any invested sum, the borrowers defaults need to increase three times. While it is possible to improve regulation of P2P lending, the current regulatory framework is still proportionate and targeted. Also, investors understand well the risks involved. This is quite important especially at a time which the industry has been facing public criticism. P2P is sometimes categorized as an alternative lender. This is mainly because it does not fit into the 3 traditional financial institutions including investment firms, deposit takers and insurers. Some of the characteristics of P2P lending are:
- Conducted for profit
- Little to no bond or prior relationship required between lenders and borrowers
- A P2P lending company is the intermediary
- Transactions are done online
- Lenders are allowed to choose the specific borrowers that they want to invest in.
- The loans are either secured or unsecured and aren't protected by government insurance. There are, however, other protection funds such as Zopa and Ratesetter that protect this in the UK.
- Loans here are also security that can be transferred from one person to another for profit or even debt collection. However, not all P2P lending firms offer these transfer facilities and transferring the asset may be costly.
These are some of the popular services offered by P2P intermediaries:
- A platform that allows borrowers to get lenders and for investors to offer loans that match their investment criteria
- Building credit models to ensure loan approvals and pricing
- Confirming the identity, income, employment status and even bank account of the borrowers
- Conducting credit checks and filtering any unsuitable borrowers
- Ensuring compliance with the laws and legal reporting
- Marketing to find other lenders or borrowers
- Processing payments from borrowers and passing these payments to lenders
- Customer service to borrowers and collecting payment from defaulters.
List of peer-to-peer lending sponsors
These sponsors are institutions that handle loan administration for individuals and even institutions but do not invest their own money.
- They include: