What is Peer-to-Peer Lending and How Does it Work?

In recent years, lenders looking for small loans with competitive interest rates have turned to peer-to-peer lending (P2P) as a way to sidestep big financial institutions who have stopped lending money as freely as they used to, helping P2P investing become one of the fastest growing segments in the financial services industry. Born out of the 2008 financial crisis, the peer-to-peer lending model began when some companies started to developed online platforms where potential investors looking to earn returns on cash sitting in savings accounts could connect with borrowers looking for more options.

Sometimes called “social lending” or “crowd lending”, peer-to-peer lending companies act as the liaison between borrowers and investors through an internet platform – completely cutting banks out of the process. These lending platforms generate revenue by collecting a loan servicing fee to investors and by applying fees on funded loans from borrowers. After the loan has been funded, the money is released to the borrower by a partner bank and the loan company issues a note to the investor that acts as a form of security.

The lower operating costs and interest rates have made P2P lending a major competitor for the traditional banking system – and an appealing option for borrowers hunting for low-interest personal loan companies looking to diversify their investment portfolios. The streamline method also means that there is a fast turnaround for funding and fees are lower, with some peer-to-peer lenders not charging any penalties to borrowers for late or early payment.  

Borrowers tend to be people looking for unsecured loans of $1,000-$35,000 payable over 3-5 years, who don’t have access to home equity credit. These are often to help pay for small purchases - a used car, home repairs, and so on - or to consolidate their debt with a lower interest loan. Lenders tend to be individuals investing from $5,000 to $25,000, spread across a series of small, $25-$100 loans to minimize default risk. They are looking to sidestep banks and find investments that pay higher than traditional methods such as bank accounts and Certificates of Deposit (CDs).

Pros for Investors:

Lower risk 

If you’re a lender on a peer-to-peer site you have real freedom to pick and choose where to invest your money. If you’re worried about the borrowers you can keep your investment very low or just spread it across a portfolio with hundreds or even thousands of loans in order to offset the risk. 

Better yields

It’s not chiseled in stone, but peer-to-peer investors have the opportunity to get better returns on their money than they would with more traditional, conservative investments like stocks, bonds, mutual funds, and the like.  

Easy to get started 

Getting in the game is easy. You can open an investment account online easily and in no time. You can start off by investing small amounts - even as little as $25 - and then reinvest the earnings back into new loans. Managing your account is easy, you maintain total autonomy and getting up and running should be easier than you probably expected. 

Pros for Borrowers:

Better rates 

P2P sites connect the borrower and the lender directly, easily facilitating loans without you ever having to step foot inside a bank. What does this mean for your bottom line? Because P2P sites have less overhead and spread their risk over many lenders, you can often find a lower APR on a P2P site than at a traditional financial institution. This of course does depend to a large extent on your credit score, but the opportunity to save money on your loan is there with P2P lending. 

Easier application process 

When getting a P2P loan you can go online and get pre-approved within minutes. These sites have online applications that take very little time whatsoever, and you never have to go to your bank branch or even get out of bed if you don’t want to. You’ll still have to get your paperwork in order - including documents like bank statements, pay stubs, and the like, but the entire process should be much smoother. 

Fixed rates and no prepayment fee

With P2P loans you will most likely have a very clearly fixed repayment terms (typically of 24 or 36 months) which should help you manage and plan your monthly expenses. There won’t be any surprises and you’ll always know how much you own. Also, P2P lenders tend to not charge a fee for prepayment, if you come into some money and would like to pay your loan off early. 

Get money faster 

Typically the process is quicker with P2P lending and you should receive your funding within a week or two, and in some cases, within several days.

Cons for Investors:

Can lose money 

While it’s true that with peer-to-peer lending you get to diversify your portfolio to offset risk, this is by no means fool-proof. This is especially true if you go for more high risk portfolios. They do yield greater returns, but this comes with a higher degree of risk. Spread your loans out across a large portfolio and play it cautious at least at first. In addition, you are not allowed to cut your losses and sell the loan ahead of time – you are bound to the commitment made at the time of lending, which is typically for a matter of years. Also, your loans aren’t guaranteed by the federal government, so you could be left hung out to dry if the borrowers default. 

Harder to know your client

While offsetting the risk across a wide range of borrowers is a smart move, with P2P lending you’re also much less able to know your clients personally. This means you’ll have to trust the company’s determination of the risk involved with the borrower, instead of deciding on your own after performing due diligence. 

Cons for Borrowers:

Bad credit? It still won’t be easy 

You’ll probably find that with P2P lending you have an easier time getting a loan with poor credit than you would with a traditional bank. At the same time, you’ll probably pay for this by way of higher APRs, which could make it difficult to make your payments, potentially drawing you into further debt. Depending on the company, these APRs for people with bad credit can be very steep, even significantly higher than the interest on credit cards. 

Don’t forget the fees 

In addition to APR, with a P2P loan you’ll also have to pay origination fees, which can hover around 4% to 5% depending on the company and your credit score. These fees are typically deducted from the loan amount, which can offset the amount of money you’re actually getting. In addition, you’ll probably face additional fees for late or failed payments.

What Types of P2P Loans Are Available?

There are 4 main types of loans available with P2P lending, all of which are basically different forms of personal loans.

Unsecured personal loans

This is a very popular form of loan that borrowers often find to be less of a headache. An unsecured personal loan is one that doesn’t require you to put any collateral down to “secure” the loan. The good thing about this type of loan is that you don’t need to risk your house or car or some other form of valuable collateral, but this doesn’t come without a price. If you don’t secure the loan you stand to pay a higher APR, as you will be seen as a more risky borrower.

Secured personal loans 

If you do have collateral to put on your loan, then this may be your best option. With a secured personal loan you will have given the bank an insurance policy of sorts by way of your collateral. This will make you less of a risk for the bank, which should pay off for you by way of lower APR.

Debt consolidation loans

Done right, this can be one of the smarter, more financially-sound ways to use P2P lending to your advantage. If you have previous, high interest debts - such as credit cards or student loans - a P2P personal loan can be a great way to pay those loans off and consolidate your debt. It probably goes without saying though that this is only the case if the new loan has better terms. See what you can do to get the best terms possible, and a P2P loan to pay off those high-interest debts could really take the edge off.

Business loans

There are a number of options for entrepreneurs who are looking to get a business off the ground or just need some more cash flow to help their business soar. These can include Small Business Administration loans, microloans, and term loans, to name a few. With P2P lending you can also get a secured or unsecured personal loan which you can towards whatever it is your business needs.

Loans For Small Purchases, From Your Smartphone

One of the main draws for P2P lending is the customer experience, and the large number of lending companies consumers can choose from. Borrowers can shop interest rates without leaving the house and lenders can track their portfolio with a few clicks on their smart phone. Both lender and borrower can bid adieu to long lines at their local bank branch, where approval for a loan can take days rather than mere minutes on a P2P platform.

Lending companies make their money by charging fees to borrowers, taking a percentage of the loan repayments to investors, and collecting fees for defaulted loans, in addition to other service fees.

We recommend potential investors and borrowers read reviews of some of the industry’s top P2P platforms, including SoFi and LendingTree.

What to Consider:

Hidden Fees

Although P2P lending provides significant advantages to both investors and borrowers, you still need to do your homework. One thing to note is there are fees involved – including origination fees - that can range from 0.5% to more than 5% of the loan. Be sure to read the fine print and fully understand the total cost of the loan by the time it’s paid off.

Some lending companies charge contributions to “bad-debt provision funds” – which are set aside to help protect the lending company from losses. Because the loans are taken out with no collateral, P2P companies can sell the defaulted loans to a collection agency or take out a court order against the borrower.

Rise in Interest Rates

An average interest rate of a peer-to-peer loan is roughly 15% but if you have fantastic credit you can get rates as low as just over 5%. That said, those with poor credit can get stuck with much higher interest rates – as high as 30.99% for the riskiest borrowers at LendingClub – an industry leader.

Experts believe that if interest rates continue to increase, the industry could see higher costs for borrowers – and better returns for investors – perhaps leading to a bubble in the industry. Regardless, average interest rates on P2P loans are not likely to exceed those of credit cards, and as long as the economy is doing well and unemployment remains relatively low, the number of defaults shouldn’t raise any red flags.

Loan Term

Most peer-to-peer loans are only three to five year, fixed monthly payments, though many loans are stretched out over a longer period, with lower monthly payments and higher interest rates. This is yet another reason these loans are becoming favored - low interest with a fixed term for the repayment.

Bad Credit

Prior to 2008, lenders were focused on borrowers with credit scores over 640. Today, some P2P sites welcome borrowers with scores as low as 580, though they stand to pay higher interest rates than lower risk borrowers. In addition, some of the top peer-to-peer lenders look beyond just your credit score, factoring in considerations such as work history.

Regulations

In 2008 the Securities and Exchange Commission began to regulate the P2P industry and on the borrower side, agencies such as the Consumer Financial Protection Bureau and Federal Trade Commission now regulate the P2P industry. P2P platforms are subject to the same federal rules that govern all consumer credit company such as Equal Credit Opportunity Act and Fair Debt Collection Practices Act and borrowers are protected by state regulations against misleading advertising and discriminatory practices.

In 2016, growth for the P2P industry began to stumble under heightened regulation, leading many financial analysts to question predictions that the online lending platform poses a threat to traditional banking. Nonetheless, the industry is still on the rise and P2P loans remain an inexpensive way to consolidate a debt with a loan. We just want you to make sure that it is something you are prepared for and ready to face head-on.

So, What’s Next?

It’s up to you to determine if a peer-to-peer loan is the right way for you to get on the road to pay-off your debts or a ticket to higher returns on investment than your bank account or CD. If you compare peer-to-peer loans that are available and do some homework you can take part in an industry that is user friendly and has great potential for reward – all from the comfort of your home. For more information on P2P loan companies, read our reviews of top companies.

APR Rates

The APR calculation on personal loans varies according to lender, but the rates on these loans are generally lower than what you would typically receive from a payday loan, starting at 10% and capping at 35.99%. 

APR rates mentioned include associated fees.

Full repayment for the loans displayed range between 61 days to 180 months.

Representative example: assuming a loan of $10,000 over 60 months at a fixed rate of 3.1% per annum and fees of $60.00. This would result in a representative rate of 3.3% APR, with monthly repayments of $180.80, for a total amount paid of $10,848.00.

* LightStream Terms and Conditions:

*Your loan terms, including APR, may differ based on loan purpose, amount, term length, and your credit profile. Rate is quoted with AutoPay discount. AutoPay discount is only available prior to loan funding. Rates without AutoPay may be higher. Subject to credit approval. Conditions and limitations apply. Advertised rates and terms are subject to change without notice. Payment example: Monthly payments for a $10,000 loan at 4.99% APR with a term of 3 years would result in 36 monthly payments of $299.66. SunTrust now Truist is an Equal Housing Lender. © 2020 Truist Financial Corporation. SunTrust®, Truist, LightStream®, the LightStream logo, and the SunTrust logo are service marks of Trust Financial Corporation. All rights reserved. All other trademarks are the property of their respective owners. Lending services provided by SunTrust now Truist Bank. Truist Bank is an Equal Housing Lender. © 2022 Truist Financial Corporation. Truist, LightStream, and the LightStream logo are service marks of Truist Financial Corporation. All other trademarks are the property of their respective owners. Lending services provided by Truist Bank.

*  Marcus By Goldman Sachs® Offer Terms and Conditions:

Your loan terms are not guaranteed and are subject to our verification of your identity and credit information. To obtain a loan, you must submit additional documentation including an application that may affect your credit score. The availability of a loan offer and the terms of your actual offer will vary due to a number of factors, including your loan purpose, our evaluation of your creditworthiness, your credit history, if we have recently declined your loan application and the number of loans you already have with us. To obtain a loan, you must submit additional documentation including an application that may affect your credit score. Rates will vary based on many factors, such as your creditworthiness (for example, credit score and credit history) and the length of your loan (for example, rates for 36 month loans are generally lower than rates for 72 month loans). Your maximum loan amount may vary depending on your loan purpose, income and creditworthiness. Your verifiable income must support your ability to repay your loan. Marcus by Goldman Sachs is a brand of Goldman Sachs Bank USA and all loans are issued by Goldman Sachs Bank USA, Salt Lake City Branch. Applications are subject to additional terms and conditions. You may be required to have some of your funds sent directly to creditors to pay down certain types of unsecured debt. Receive a 0.25% APR reduction when you enroll in AutoPay. This reduction will not be applied if AutoPay is not in effect. When enrolled, a larger portion of your monthly payment will be applied to your principal loan amount and less interest will accrue on your loan, which may result in a smaller final payment. See loan agreement for details.

* LendingClub Terms and Conditions:

A representative example of loan payment terms is as follows: you receive a loan of $13,411 for a term of 36 months, with an interest rate of 12.16% and a 5.30% origination fee of $711, for an APR of 15.99%. In this example, you will receive $12,700 and will make 36 monthly payments of $446.46. Loan amounts range from $1,000 to $40,000 and loan term lengths are 36 months or 60 months. Some amounts and term lengths may be unavailable in certain states. APR ranges from 8.05% to 35.89% and is determined at the time of application. Origination fee ranges from 3% to 6% of the loan amount. Lowest APR is available to borrowers with excellent credit. Advertised rates are subject to change without notice. Loans are made by LendingClub Bank, N.A., Member FDIC (“LendingClub Bank”), a wholly-owned subsidiary of LendingClub Corporation, NMLS ID 167439. Loans are subject to credit approval and sufficient investor commitment before they can be funded or issued. Certain information that we subsequently obtain as part of the application process (including but not limited to information in your consumer report, your income, the loan amount that your request, the purpose of your loan, and qualifying debt) will be considered and could affect your ability to obtain a loan from us. Loan closing is contingent on accepting all required agreements and disclosures at Lendingclub.com. “LendingClub” is a trademark of LendingClub Bank.

* Freedom Terms and Conditions: 

The financial solutions for which you will be evaluated are offered by service providers with which we are affiliated and/or compensated by who participates on our website. Terms and conditions apply to each, and not all are available in every state.

The financial solutions for which you will be evaluated are offered by service providers with which we are affiliated and/or compensated by who participates on our website. Terms and conditions apply to each, and not all are available in every state.

Achieve.com, a d/b/a of Bills.com, LLC (NMLS ID #138464) operates as a marketing lead generator for affiliates and non-affiliates, and as a broker for loans and debt resolution services offered by its affiliates. We also offer certain mobile applications that allow consumers to view and analyze their finances. We may take applications for our affiliates, but we do not make credit decisions, originate loans, process consumer loans or bill payments, or provide any other financial services. We do not collect any fees or other compensation from consumers.

Personal loans are available through Achieve Personal Loans (NMLS ID #227977), originated by Cross River Bank, a New Jersey State Chartered Commercial Bank or Pathward N.A., Equal Housing Lenders and may not be available in all states. All loan and rate terms are subject to eligibility restrictions, application review, credit score, loan amount, loan term, lender approval, credit usage and history. Loans are not available to residents of all states. Minimum loan amounts vary due to state specific legal restrictions. Loan amounts generally range from $5,000 to $50,000 (including the origination fee) and are offered based on underwriting conditions and loan purpose. APRs range from 7.99 to 29.99% and include applicable origination fees. Repayment periods range from 24 to 60 months.

For example: A four-year $20,000 loan with an APR of 18.34% would have an estimated monthly payment of $561.60 and total cost of $26,956.80. To qualify for a 7.99% APR loan, a borrower will need excellent credit, a loan amount of $12,000.00 or less, and a term of 24 months.

Loan origination fees vary from 1.99%to 6.99%, most loans have a fee of 4.99%. Adding a co-borrower with sufficient income; using at least eighty-five percent (85%) of the loan proceeds to pay off qualifying existing debt directly; or showing proof of sufficient retirement savings, could help you also qualify for a lower rate. Average interest savings for personal loans range from 0% - 6% based on closed loans that qualified for one or more of our rate discounts in July 2022.

†Times noted are estimates and can vary for a loan request from Achieve Personal Loans (NMLS #227977). Same day approvals assume that a fully completed application with all required supporting documentation is provided early enough on a day that our offices are open. Achieve Personal Loans consultants are available Monday–Friday 6AM to 8PM MST and Saturday–Sunday 7AM to 4PM MST.

‡ Upgrade Terms and Conditions:

Personal loans made through Upgrade feature Annual Percentage Rates (APRs) of 8.49%-35.99%. All personal loans have a 1.85% to 9.99% origination fee, which is deducted from the loan proceeds. Lowest rates require Autopay and paying off a portion of existing debt directly. Loans feature repayment terms of 24 to 84 months. For example, if you receive a $10,000 loan with a 36-month term and a 17.59% APR (which includes a 13.94% yearly interest rate and a 5% one-time origination fee), you would receive $9,500 in your account and would have a required monthly payment of $341.48. Over the life of the loan, your payments would total $12,293.46. The APR on your loan may be higher or lower and your loan offers may not have multiple term lengths available. Actual rate depends on credit score, credit usage history, loan term, and other factors. Late payments or subsequent charges and fees may increase the cost of your fixed rate loan. There is no fee or penalty for repaying a loan early. Personal loans issued by Upgrade's bank partners. Information on Upgrade's bank partners can be found at https://www.upgrade.com/bank-partners/.

*  Reach Financial Terms and Conditions:

All loans are subject to eligibility criteria and review of creditworthiness and history. Terms and conditions apply. All loans advertised are unsecured personal loans issued by either Metabank® National association, member FDIC, or FinWise Bank, a Utah chartered commercial bank, member FDIC, as creditor, on the Liberty Lending platform. If you are approved for a loan, the interest rate offered will depend on your credit profile, your application, and the loan term you select. Fixed Annual Percentage Rates (APR) range from 5.99% to 35.99%. You could receive a loan of $10,000 with an interest rate of 8.93%, an origination fee of $200, for an APR of 9.80%, which would result in total payment of $12,435 with 60 monthly payments of $207.20. Your actual rate may differ and depends on your credit history, loan amount, and term. Total approved loan amount reflects origination fee, which ranges from 0% to 5%. *Within 24 hours of your loan approval, loan proceeds will be available to pay the creditors named on your Truth-In-Lending Disclosure.