Peer-To-Peer Lending Definition
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.
A Little More on What is Peer-To-Peer Lending
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 charecteristics 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 transfering 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 acoount 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:
References for Peer to Peer Lending
Academic Research on Peer to Peer Lending
Judging borrowers by the company they keep: Friendship networks and information asymmetry in online peer–to–peer lending, Lin, M., Prabhala, N. R., & Viswanathan, S. (2013). Management Science, 59(1), 17-35. This study assesses the online market for P2P lending where individuals bid on unsecured loans that other individuals or even commercial entities seek. It used a sample of failed listings from Prosper.com, the largest P2P lending marketplace. The research found that online friendships of the borrowers act as a signal of the quality of a creditor. Social friendships were found to increase the chances of being funded, lowered post default rates and even lower interest rates on the loans received. Our findings are then discussed to show the implication of the study on the disintermediation of securities markets and design of decentralized electronic markets.
Trust and credit: The role of appearance in peer–to–peer lending, Duarte, J., Siegel, S., & Young, L. (2012). The Review of Financial Studies, 25(8), 2455-2484. It is known that appearances have implications on the labor market and even in election outcomes but little has been discussed on the role of appearances in financial transactions. This issue is addressed by reviewing pictures of potential borrowers of a P2P lending site. Due to the trust-intensive nature of lending, it was found that borrowers that look more trustworthy were much more likely to have their loans funded. Those who appear more trustworthy were also found to have better credit scores and did not default as often. The findings posited that trustworthiness is important in financial transactions it can help predict a borrowers behavior as well as investor’s behavior. As John Pierpont Morgan posited, a man that I do not trust cannot get money from me on all the bonds in Christendom.
Peer to peer lending: auctioning microcredits over the internet, Klafft, M. (2008). P2P lending platforms allow private lenders to invest their funds while also making it possible for borrowers to request for loans online. These platforms were introduced in 2005 and have been on the rise over the recent years. While this loaning structure has been there for a while, little is known about the success of loan listings and interest rates. The paper assesses 54077 listings from Prosper.com and asserts that having verified bank information and credit rating is key to a succesful listing. Other important factors include additional personal information and peer groups. Interest rates were found to depend on credit rating and debt to income ratio. It was also found tat P2P lending does not differ from conventional banking system but it lowers the cost of borrowing by eliminating the intermediary banks.
Do social networks solve information problems for peer–to–peer lending? evidence from prosper. com, Freedman, S., & Jin, G. Z. (2008). The paper aims to study peer-to-peer lending on the internet by reviewing prosper.com, one of the first P2P lenders in the US. It uses transaction data from June 1, 2006 to July 31, 2008 to determine the problems that P2P lenders face and if social networks can address these issues. Three problems were identified including adverse selection because lenders do not observe actual credit scores. Second, prospective lenders make mistakes on loan selection but learn from it later. Third, a higher interest rate signifies a lower rate of return. Evidence was found for and against microfinance theories that suggest social networks identify good risks and a stronger incentive to pay off loans.
Do unverifiable disclosures matter? Evidence from peer–to–peer lending, Michels, J. (2012). The Accounting Review, 87(4), 1385-1413. A lot of research studies have been conducted on the role of disclosure in reducing market inefficiencies. Voluntary, costless and unverifiable disclosure is not likely to be a credible source of information but past studies have shown that a person’s decision can be altered by uninformative content. The study uses a unique dataset from a P2P lending site to show the effect of unverifiable disclosure in lowering debt costs. The results assert that unverifiable disclosure leads to a 1.27% reduction in interest rates and 8% increase in bidding activity.
Online peer–to–peer lending: a lenders’ perspective, Klafft, M. (2008). P2P platforms often claim to be profitable to both lenders and borrowers by removing the intermediaries and reducing transaction costs. It is, however, worth asking whether the novice lenders operating in a pseudonymous online environment get an attractve rate of return. This paper explores this issue while using profitability data from Prosper.com. The findings is that while the overall investment performance has not been satisfactory, following some simple investment pointers can ensure an acceptable rate of return.
Screening in new credit markets: Can individual lenders infer borrower creditworthiness in peer–to–peer lending?, Iyer, R., Khwaja, A. I., Luttmer, E. F., & Shue, K. (2009). The banking crisis of 2008, revealed some of the challenges that traditional models of banking faces especially with regards to screening small borrowers. The growth of P2P lending offers a chance to review some of the alternative financing models. It was found that these market based structures offer a lot of screening advantages but the lenders often lack financial knowledge and lending experience. The paper assesses whether the investors in P2P lending can use borrower information to get the credit worthiness of borrowers. The findings assert the screening ability of P2P markets and propose that they may be a viable compliment to traditional lending.
The democratization of personal consumer loans? Determinants of success in online peer–to–peer lending communities, Herzenstein, M., Andrews, R. L., Dholakia, U. M., & Lyandres, E. (2008). Boston University School of Management Research Paper, 14(6). Online P2P platforms and communities allow people to borrow from and lend cash directly to each other. This study looks at bpth the borrower and loan listing related to determinants of success in getting P2P funds. It conceptualizes the variables of getting a loan including the amount, duration of listing and loan interest accrued. The results that used 5,370 completed P2P loan transactions supported the proposed conceptual framework. The paper offers borrowers a number of suggestions to help increase their chances of being funded in P2P platforms. It also discusses future opportunities for research.
Evaluating credit risk and loan performance in online Peer-to-Peer (P2P) lending, Emekter, R., Tu, Y., Jirasakuldech, B., & Lu, M. (2015). Applied Economics, 47(1), 54-70. P2P lending has recently emerged as a micro loan market that could have some benefits to both lenders and borrowers. The article uses data from the Lending Club, a popular online P2P lending house. It was found that a couple of factors influence loan defaults and this include credit grade, debt-to-income ratio, line utilization and FICO score. Results were in line with the Cox Proportional Hazard test that proposes that the harzard rate increases risk of the borrowers. It was also found that higher interest rates that were charged on high-risk borrowers wasn’t sufficient to compensate for the probability of loan defaults.
Peer–to–peer lending and community development finance, Galloway, I. (2009). Community Investments, 21(3), 19-23. P2P lending, that has grown so fast over the recent past promises a lot for various stakeholders. The growth of the industry also has promising effects for innovations in community development.
A trust model for online peer–to–peer lending: a lender’s perspective, Chen, D., Lai, F., & Lin, Z. (2014). Information Technology and Management, 15(4), 239-254. P2P lending is a new finance method for individuals and small business that is conducted on the internet and does not rely on financial institutions. Since there is no collateral, it is important to address the risk of this financing method. The study uses trust theories to develop a trust model for online P2P lending. The model uses 785 online lenders of PPDai, one of the largest P2P lending platform in china, to determine what influences a lender’s trust. The findings assert that borrowers should offer high quality information prior to their loan requests and platforms should ensure enough security protection.
Is crowdfunding different? Evidence on the relation between gender and funding success from a German peer‐to‐peer lending platform, Barasinska, N., & Schäfer, D. (2014). German Economic Review, 15(4), 436-452. The current literature on conventional banking highlights discrimination against female borrowers. A review of P2P lending literature, on the other hand, reveals that females have better chances of getting funded than their male counterparts. The study provides evidence to show that females in a german P2P lending firm have better chances of successful lending. It concludes that female discrimination has been reduced by the social lending platforms.
Market mechanisms in online peer–to–peer lending, Wei, Z., & Lin, M. (2016). Management Science, 63(12), 4236-4257. P2P lending has grown significantly over the past but there remains some fundamental questions that are unanswered with regards to the choice of market mechanisms. These include how supply and demand are matched, the terms of the transaction. The two popular mechanisms include posted prices where the platform decides the price and auctions where the public decides the prices. This study explores the impact of using one or the other mechanism on market participants, social welfare and even transaction outcomes. It finds that under posted prices, loans are funded with a higher probability. While the use of posted prices may help originate loans faster, auctions are also relatively good when it comes to social welfare.