Advantages and Disadvantages of peer to peer lending

If you wanted to borrow money for home improvements, education, or starting a small business, seeking out a personal loan from a bank is a natural first option. However, a new trend has come up in the last few years, allowing consumers to skip the banks or intermediaries and go straight to individual investors known as peer to peer lending.

In this article we’ll talk about the advantages and disadvantages of peer to peer lending, and how you can start borrowing or investing.

Disclaimer: This article contains paid affiliate links. By you clicking on the affiliate link and making a purchase, I receive a commission (at no additional cost to you).

What is Peer to Peer lending and how does it work?

Peer to Peer lending is a system in which individuals fund loans (partial or whole) for individual borrowers. This system allows the borrower to skip the banks and go directly to individual lenders.

Peer to peer lending has two sides: the borrower and the lender. Let’s look at the role each plays and the advantages and disadvantages of peer to peer lending.

Borrower: A borrower will fill out an application with the loan specifics for approval. The interest rate for the loan will depend on the borrower’s credit history, the loan amount, debt to income ratio, etc. The qualified interest rate is where P2P lending doesn’t differ too much from traditional lending; the interest rate is still dependent on the borrower’s credit history (although you may find slightly better rates through P2P lending). However, a P2P loan may be easier on your credit score. When shopping for an interest rate through a bank, your credit score will incur a hard inquiry which can lower your score. A P2P loan will incur a soft inquiry which means there is no effect to the score. However, be aware that at the final stage or approval, you will get hit with a hard inquiry should you decide to accept the terms of interest which can lower your score. (1)
Investor: The investor functions like a bank in that he/she reviews the loans on the platform and then decides whether to invest. The investor can opt to fund the loan in full, or through a partial loan. Partial loans are known as notes and can be funded in increments of $25). In return, the investor receives monthly payments plus an interest rate (similar to how a bank is paid).

I want to get a loan-how do I go about that?

The loan process involves five main steps:

Submit the usual background information (name, address, DOB) and the different lenders will determine how much they’re willing to lend and at what interest rate (this is the soft inquiry we talked about before).
Assuming you shopped around through different platforms for loan terms, you will go through a more detailed credit check including a hard inquiry on your credit score. You may be asked to submit additional information.
Once you’re approved by the marketplace, investors will review your loan and decide if they want to fund it.
After your loan is funded you’ll receive your money.
You’ll now receive a payment schedule-you don’t have to pay back individual investors. Rather, you’ll pay one payment to the marketplace.

As an investor, how do you decide which loans to fund?

Deciding which loans to fund can be daunting especially if you don’t know much about the borrower. After all, this is a business not a charity so you’re expecting a return on your investment. To aid in the process, P2P lending sites will assign a grade to the loan. For example, Prosper (the original P2P site) offers grades from A-HR. Each grade is assigned an average return. The higher the grade (A), the safer the investment, and vice versa for the lower grades. (2). This grading system helps investors identify the level of risk associated with each loan. Please note that grades and average returns will vary by platform.

What are some of the advantages?

From the borrowers point of view….

This can be a good alternative if you have a low credit score and can’t secure a personal loan from a bank.
Shopping for a loan will be easier on your credit via soft inquiry. Note however that once you agree to a rate, your credit will endure a hard inquiry in the final steps.

From the investors point of view…

Peer to peer lending can be a nice way of diversifying your portfolio.
You have control over which loans you choose to fund so you control your level of risk.

What are some of the disadvantages?

P2P loans are not FDIC insured so if the borrower defaults on his/her loan payments, as the investor you have few options on how to get that money back.
Not all states allow for P2P lending so depending where you live you may not qualify.
Most P2P lending services charge a fee for investors and borrowers (typically 1-5%).
As a borrower, there are caps on the dollar value you can borrow. These caps will depend on which lender platform you choose but typically max out around $40,000-$50,000.
Peer to peer loans will still show up on your credit reports just like traditional loans from a bank so treat them with the same gravity.

What are the best apps for P2P lending?

Propser: The original peer to peer lending app founded in 2005. As a borrower you can take on a loan up to $40,000. On their website they offer low fixed rates for either 3 or 5-year terms. As noted earlier as an investor you have opportunities to invest in different types of loans with different risk levels starting with just a minimum investment of $25.
Upstart: Upstart is a unique peer to peer platform in that they use their own AI/machine learning technology to assess a borrower’s risk, which can lead to lower losses for investors. They also provide technology solutions to banks to aid in their client’s portfolio performance.
Peerform: Founded by Wall St executives, their platform is dedicated to helping dependable borrowers. On their website they tote their desire to create a fair marketplace with a positive experience for both borrowing and investing.
Rocket Dollar: Not just a platform for peer to peer lending but allows for “self-directed” retirement investing. This platform allows you to invest in a multitude of IRS approved asset classes. (paid link)

Sources:

(1) What is Peer to Peer Lending, Experian. Jim Akin. January 29, 2020. https://www.experian.com/blogs/ask-experian/what-is-peer-to-peer-lending/

(2) Why Invest With Prosper. https://www.prosper.com/invest/?amp