Finance 101: What the Heck is Peer-to-Peer or P2P Lending?

This is part two in my Finance 101 series and it’s a long one. This time we’re learning about peer-to-peer, person-to-person, social, P2P or sometimes micro lending. The concept has many names but it’s basically the same thing – you are getting a loan from a private individual instead of a bank. That’s the short, short version for those without the time to stick around for the article. The rest of this post is directed to those who are completely clueless about the process. Read on.

Let’s begin with the most basic. According to Wikipedia, this is a type of lending or borrowing “which occurs directly between individuals (‘peers’) without the intermediation/participation of a traditional financial institution.” I like my definition better. You’re thinking, well how does this work? Let’s look at two scenarios.

Scenario #1: You need a personal/debt consolidation/car/you-make-it-up loan.
It doesn’t matter why you need a loan but you go to a bank to get a loan and for one reason or another you can’t get one or the rate that is quoted to you is not what you want to pay. Perhaps the bank wants you to secure the loan with an asset, which you don’t want to do. Perhaps you already have a loan or you want to consolidate your debts at a lower interest rate but the rate that your bank quotes is too high. Perhaps your credit is shot and you want to try rebuilding your credit by taking out a small loan and paying it off within three months or so. Whatever the reason, you need an alternative to what you’ve been offered. You want to borrow $5,000.

Scenario #2: You want to make more than 0.01% interest on your money.
You’ve been diligently saving money but noticed that ING has lowered your rate every month until it’s now down to 1.25% interest. Maybe it’s even worse and you have your money in a big bank’s saving account getting 0.01% interest (Chase!!!!!) and you are willing to take on some risk to make more money. You are willing to risk lending $500.

P2P marketplaces connect borrowers seeking loans with lenders willing to take on risks by lending their money to potential borrowers. As a borrower you have the option of creating what amounts to an advertisement or auction stating why you want to borrow the money and setting the amount of interest that you are willing to pay. Let’s say our person from scenario #1 is willing to pay 12% interest on a 3 year loan of $5,000 to consolidate 2 credit cards debts. He is currently paying 22.99% on his credit cards so this represents a significant saving for him. Without giving this borrower’s name and address, the marketplace would pull information from his credit report disclosing his credit score, amount of debt he has, whether he owns a home, debt to income ratio, any accounts in default as well as his current salary range and length of time at his job. The marketplace would also assess the probability of this person to pay back the loan in full. Let’s say he gets a score of 8 on a 1-10 scale.

The lender sees the borrower’s advertisement and is willing to lend to him, but the borrower doesn’t want to put all of his eggs in one basket so he’s willing to lend only $200 to the borrower. You’re now thinking, well that doesn’t equal the $5,000 that the borrower needs so how does this work? Well, the marketplace would pool this lender’s money with money from many other lenders until the total money offered reaches $5,000.

Once the money offered reaches the total that was asked for the borrower can end the advertisement and go through the process of accepting the loan. A smart borrower though would leave the advertisement up because it now effectively turns into a reverse auction. Lenders can still offer the borrower money, but now they can offer money at lower interest rates than the borrower asked for and they can outbid each other. So now lenders will “bid” on the loan and offer say 11.8% interest. Maybe the next offers will go to 11%, or 10%. You get the idea. Once a loan is fully funded (meaning that you get offers equal to the total amount that you wanted) then it’s smart to leave your advertisement up to get a better rate. Always begin the ad with the maximum interest that you are willing to pay or your loan may not get funded if the interest rate is not attractive enough for lenders to take on the risk.

Once the loan is completed and the borrower pays each month, the lender will get a portion of each payment that is equivalent to his portion of the loan plus interest. If you funded 1% of a loan, you will get 1% of each payment which includes interest deposited into your lending account every month. Most loans are for 3 years so if a borrower takes the full three years to pay, that is how long it will take for you to get your principle plus interest. A longer loan repayment will maximize your interest. If the borrower repays earlier than the 3 year term you won’t make as much money as a longer loan period, and the borrower also pays no prepayment penalties. Remember, there is always a risk that someone will default so do not lend money that you are not willing to lose. These loans are not secured by anything, but you can refer any defaulted loans to a collection agency to recoup losses.

More Things for Borrowers:

  • You will have to pay an application fee (usually only if you accept the loan) so factor that in to your calculations.
  • Suggested interest rates are based on various factors, which include your income, credit score and payment history.
  • You don’t have to accept a funded loan.
  • This loan will show up on your credit report.
  • Your employment and income is verified by showing pay stubs.

More Things for Lenders:

  • You can help to fund multiple loans at the same time.
  • Minimum lending amount per loan is $25.
  • The worse a borrower’s profile, the higher interest you can command.
  • Even the best borrower can default.
  • Prosper allows you to sell you loans to others.
  • Your interest is reported on an IRS 1099 Form.

Two of the largest P2P marketplaces are Lending Club and Prosper. You can also be nice and socially conscious and lend money to individuals in third world countries through Kiva.

Finally, I like this kind of lending because I feel like I have a personal interest in improving someone’s financial situation. I know who is getting my money although I never fully believe what people say they are using the money for. Plus, it’s not 100% altruistic. I get to make money on what I lend out at a rate that is more than 80x what Chase was giving me (my loans average 8.25% interest).  That’s just about all the major points! I hope this one wasn’t too confusing.

If you would like to see how have done as a lender, please visit my review of one year as a lender.  If you’d like learn more about investing on Lending Club, please view Investor Junkie’s Lending Club review. Now go forth and borrow…or lend.

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