What is a peer-to-peer loan and how do they work?
There are many different types of personal loans available to cover life’s significant expenses or purchases. The most common options include unsecured personal loans, which do not require providing any collateral, and secured personal loans, which are backed by an asset such as a car or a home.
Peer-to-peer (P2P) loans, which allow individuals to borrow money without relying on a conventional financial institution, are perhaps a less well-known option. These loans are made by investors and can offer many benefits, including being easier to qualify for and more flexible in terms of how the proceeds can be used.
What is a peer-to-peer loan?
A P2P loan is a loan made by one or more investors to individual borrowers. These transactions are typically facilitated through online platforms rather than traditional banks. Some of the best-known P2P platforms currently operating include Kiva, LendingClub, Upstart, and Prosper.
This type of unconventional loan dates back to about 2005 when a fintech named Zopa launched what’s considered to be the first P2P lending model, according to the industry website, BeyondP2P. Prosper and LendingClub followed shortly after.
Over the years, some of the P2P platforms have evolved their lending model to include more than just individual investors.
“As Kiva’s P2P lending platform has grown and proven effective, we’ve scaled our investing activities to go beyond P2P lending alone and include funding from institutional investors and high net worth individuals through Kiva Capital, our asset manager that supports underserved communities,” says Kathy Guis, a vice president with Kiva, a nonprofit that allows people to lend money to others.
How peer-to-peer loans work
Peer-to-peer loan agreements between borrowers and lenders are facilitated and enabled by an intermediary such as a fintech platform. These platforms process applications and move them through underwriting, collect funds from the investor lenders, and then provide the money to selected borrowers.
"These same intermediary companies will also collect the repayments and distribute the proceeds to investors,” says Michael Sullivan, personal financial consultant with the nonprofit debt management and credit counseling agency Take Charge America.
One of the major attractions of P2P loans is that the proceeds can be used for pretty much anything, including home improvement, debt consolidation, and other major expenses. The uses for a P2P loan can even include paying for the cost of office supplies for a new business startup or to support traditionally overlooked or marginalized borrowers.
“Kiva’s P2P loans most often support people the traditional financial sector too often fails to reach, particularly women, refugees, and displaced populations, small farmers, and historically underserved minorities here in the U.S.,” says Guis.
Nearly any type of loan request is potentially fundable if the investment is attractive to a particular lender.
How to apply for a peer-to-peer loan
The process of applying for a P2P loan is fairly straightforward and not all that unlike applying for other types of lending or even lines of credit.
“The entire process is typically online and simple,” says Sullivan. “It often mirrors applying for a store credit card.”
1. Research the options
The first step when applying for any type of borrowing should be to research your options and ensure you’re getting the most competitive rate and loan terms possible.
“As with any financial transaction, the first consideration for a borrower is cost. Some lenders offer terms that include fees in the payments, but many require upfront fees of 1% to 8% or even more,” says Sullivan.
It’s also important to make sure you’re working with a reputable lender. To ensure this is the case, research customer reviews for a lender or look for its profile or rating on the Better Business Bureau (BBB) website.
2. Apply for preapproval
Once you’ve identified a few P2P lenders you’re interested in working with, you can seek preapproval. This step would be followed by completing a full application with the specific P2P lending platform you’d like to move forward with.
Submitting a full application can take anywhere from 20 to 30 minutes and typically involves providing various financial details, including income documentation, along with a breakdown of your monthly debt payments.
If you’re seeking P2P funding for business-related needs, you will likely be required to provide additional information. “If you need a P2P loan to start a business, then a detailed, forward-thinking business plan will make your company and loan application stronger,” says Guis. “You should also start thinking about your cash flows and how you would repay a loan if you get one.”
3. Wait for investor funding offers
Once your application is approved, there may be a waiting period while potential investors review your request and decide whether they want to take part in funding the loan. This may be followed by the applicant being provided with various lending offers from investors to review. The applicant can then select one of the options to move forward with.
4. Receive proceeds
Once the loan has been funded, the proceeds will be electronically transferred to an account that you designate.
Fees associated with P2P loans
As with any type of loan, there may be fees associated with P2P borrowing, and these should be figured into your repayment budget. Some P2P loans include origination fees, and these can be as high as 8% of the loan amount.
“Origination fees are substantial for most peer-to-peer loans since they represent the bulk of the company’s income,” says Sullivan. “Interest rates are also typically higher than most traditional loans in order to provide motivation for the lenders to accept the risk.”
However, not all P2P platforms charge borrowers a fee. Some don't charge any fees for domestic borrowers.
Pros and cons of peer-to-peer loans
As with any type of loan, there are benefits and drawbacks to consider before proceeding, including fees, repayment terms, interest rates, and more.
May be easier to obtain approval: Because P2P lenders take more than simply one's credit profile or income into consideration, these loans can be easier to obtain, even if you have a low credit score. P2P loans have provided a valuable option for typically underserved populations.
More flexibility with how funds are used: P2P loans can be used for nearly any purpose, including helping to cover the costs associated with a small business and even small farming operations.
Approval and funding process can take longer: Because these loans are made by individual or institutional investors rather than traditional banks, the timeline between approval, funding, and deposit of proceeds into your account can take somewhat longer than other types of loans.
Not widely available: Though this style of loan was established years ago, there’s still only a handful of platforms offering them.
Higher fees: Some P2P lenders may charge origination fees as high as 8% of the loan amount, though this is not the case with all. Some P2P loans don’t have any fees at all.
P2P loans offer a valuable funding alternative for significant expenses, particularly for individuals who may have trouble qualifying for traditional loans. These types of loans take far more into consideration than simply your credit score. But a P2P loan may not be the best choice if you need cash quickly or you're concerned about paying steep origination fees.
This story was originally featured on Fortune.com
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