What is Peer to Peer Lending?
Peer to peer lending also known as P2P lending refers to a modern business of money lending transactions taking place online i.e. digitally where the money is borrowed and lent between individuals or groups of individuals without involving any third-party institution such as a bank or financial authority.
- Peer to peer lending is also called social lending as it connects borrowers directly to investors and lenders. Under this transaction, the service provider sets the rates, terms, and other conditions of the transaction.
- This service is offered digitally reducing the amount of investment in overhead costs like building, office, etc, and operate at a lower overhead rate by providing services cheaply than traditional financial institutions such as banks.
- In such types of transactions, lenders earn higher returns compared to savings and investment products offered by banks.
Some of the characteristics are as follows:
#1 – Online Transaction
Transactions take place online. Most of the transactions where peers are involved take place through an online medium. There are many P2P lending investment websites such as lendingclub.com, Upstart, Prosper, etc that offer these services.
#2 – Existence of Relation
It is not required to have a common bond or prior familiar relationship between borrowers and lenders for the transactions to take place. Any unknown individuals may come together for the transaction. People sitting in remote areas can also enable the transaction easily.
#3 – Availablity of Options
Lenders may often choose which borrowers to invest in if the P2P lending platform offers this facility. It helps in matching lenders with potential buyers where chances of getting interested is high and safe
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#4 – Type of Loans
Loans can be secured or unsecured in P2P lending. Most of the loans in P2P lending are considered unsecured loans as there are no government guidelines involved for the protection of such transactions.
#5 – Risk and Earning Involved
The transaction is mostly conducted for earning profit. As the lender and the borrower both get benefited from the lower interest rates than traditional financial institutions. Lenders earn higher returns as compared to a savings account, but more susceptible to the risk of loss.
#6 – Efficiency
Due to the intermediation of P2P, lending companies prove to be both time and cost-efficient.
How Does P2P Lending Work?
- The P2P lending framework works in a different manner as compared to the normal lending by bank or credit union. When a bank is involved in lending it uses its assets deposited by other customers, to fund the loan.
- While in P2P lending, in a lending platform borrowers are directly matched with investors. Here investors get a choice to evaluate and choose which loans they wish to fund. These are generally used in personal loans or small business loans.
- Here the borrower and the lender directly connect with each other and they themselves set the prevailing terms and conditions like interest rates, tenure, repayment terms, fines, and penalties, etc.
- Also, certain restrictions are placed by lenders like who can be potential investors. Marketplace lenders charge fees to borrowers and earn a percentage of interest on the loan.
Example of Peer to Peer Lending
Risk of Peer to Peer Lending
- Intensity of Risk: There is a high risk of default borrowers in P2P lending such loans are more prone to high credit risk as the borrowers possess low credit ratings which bars them from obtaining a conventional loan from financial institutions.
- Lack of Transparency: There is a lack of transparency between the parties involved in these transactions. The terms and conditions may not as clear and specific as in conventional banks and other institutions.
- Information Accuracy: The borrowers sometimes do not provide accurate information to the investors and lenders in the urge of getting loans. They may put false information about their credit history and capacity to repay the loan.
- Variation in Interest Rates: The rate of interest calculated may also be inaccurate and varies with different investors and buyers.
Peer to Peer Lending vs Crowdfunding
- Crowdfunding is a form of stake ownership whereas P2P lending is a loan funding method. Crowdfunding provides investors an equity stake in the project/ business under which the lender’s fund gets invested.
- In this way, investors gain ownership either partially or full stake of the project. The money accumulated in crowdfunding is for a single project and the time for higher returns may be much more than P2P lending.
- P2P lending is broader in respect of recipients while crowdfunding may be done to an individual for a single specific project.
- Accessibility: Sources of funding are more accessible in P2P lending than conventional loans from banking institutions. Even the borrower with a low credit rating gets the fund.
- Return: The investors get higher returns in this lending mechanism as the interest rates are decided by themselves which makes it a profitable deal.
- Cheaper Interest Rates: The loans in P2P lending comes with a lower interest rate as compared to conventional institutions due to the competition between the lenders. This allows borrowers to choose from an ocean of lenders with lower interest rates.
- Risk: Loans are exposed to credit risk in P2P lending as the borrowers with low credit ratings generally opt for such medium of funding.
- Lack of Government Interference: There is no government protection in this lending mechanism. Here the borrower and lender themselves choose their partner in transaction irrespective of insurance provided by the government for the loss, if ever.
- Restrictions: Some country’s jurisdictions do not allow P2P lending due to certain constraints regarding investment regulations.
P2P lending is mostly common in developed countries. It offers a convenient medium of lending for potential borrowers in search of funds. All types of loans are granted without issuing any asset as collateral security. Before venturing into this lending, the borrower’s credit history and terms and conditions of the transactions must be ensured. Although, peer to peer lending is a convenient form of lending both lender and buyer should remain vigilant regarding the undertaken lending transactions.
This has been a guide to what is a peer to peer lending. Here we discuss characteristics, example, risk, and how do p2p lending work along with advantages and disadvantages. You may learn more about financing from the following articles –