Peer-to-peer (P2P) lending: How does it work?
August 4, 2022 7 min read
Peer-to-peer (P2P) lending began in the United Kingdom in 2005 and came to the U.S. in 2006. The P2P lending industry has grown rapidly since then. Today, there are many different online P2P lending platforms to choose from.
You might have heard P2P lending referred to as marketplace lending, platform lending or online platform lending. Or this might be the first time you’re hearing about it at all.
So what exactly is P2P lending anyway? Whether you’re considering taking out a P2P loan, thinking about becoming a P2P lender or just curious about how this relatively new lending industry works, here’s what you need to know.
- Peer-to-peer lending directly connects borrowers with individual lenders—instead of a financial institution like a bank—using online platforms.
- Make sure you know about the potential risks of P2P lending before you decide to become a P2P borrower or lender.
- P2P lending might have looser eligibility requirements for borrowers than loans from a traditional financial institution do. But P2P loans might have higher fees, have higher interest rates and offer less support to people struggling with loan payments.
What is peer-to-peer (P2P) lending?
P2P lending uses online platforms to directly connect people who want to borrow money with people who want to lend money.
So instead of taking out a traditional loan from a bank or credit union, you borrow money from individual investors who are registered on a P2P lending platform. A P2P loan might be entirely backed by one person. Or several people might join forces to back a loan.
P2P lending platforms typically rely on automated systems and algorithms to assess applicants’ creditworthiness, set loan terms and determine interest rates.
P2P loans are also generally unsecured. That means there’s no collateral attached to the loan.
You might be able to use a P2P loan much like a loan from a traditional financial institution. For example, your P2P loan might act as a personal loan to cover a home improvement project or a small-business loan to get your company off the ground. Some P2P lending platforms, on the other hand, might only offer loans for certain types of things, like medical bills.
Like traditional lenders, P2P lenders might consider things like your debt-to-income ratio and credit scores to help them decide whether to offer you a loan. But P2P lenders might also have less strict eligibility requirements than some other lenders.
How does peer-to-peer lending work?
How P2P lending works depends on the platform. But generally, here’s how you can expect the process to go:
- Find out if you pre-qualify for a P2P loan on the P2P platform of your choice.
- Submit an official P2P loan application. Keep in mind that credit applications might trigger a hard inquiry on your credit report. And hard inquiries can impact your credit.
- Find out if your application is approved.
- If your application is approved, different investors review your loan to decide whether to fund it.
- Once your loan is fully funded, you get an electronic transfer of funds for the loan amount.
- You make your loan payments.
- Your payments are distributed to your loan’s investors.
Is peer-to-peer lending legal?
As the Consumer Financial Protection Bureau (CFPB) notes, P2P lending hasn’t been around as long as traditional bank lending. So the P2P lending industry hasn’t had the same history of government supervision and oversight.
But P2P lending platforms have to follow state and federal laws—just like any other lender.
Is peer-to-peer lending safe?
Taking out any kind of loan comes with risks. And if you’re considering a P2P loan, you should know what to look out for so you can make the smartest decision you can.
Safety tips for P2P lending
Here are a few ways you can help keep your money safe when taking out a P2P loan:
- Do your research and make sure the P2P lending platform is reputable.
- Be on the lookout for phishing scams.
- Keep your online accounts safe with multifactor authentication and strong passwords.
The CFPB also recommends shopping around before you commit to a loan. You should compare things like fees, loan terms, interest rates and penalties for late payments or early payoff. Plus, the CFPB says to look beyond the monthly payments and think about the total cost of the loan.
Considering a P2P loan to refinance current debt? If so, it’s important to think about the whole picture.
For example, you should know how any changes in the loan terms—switching from a fixed interest rate to a variable interest rate, for example—could affect your finances in the long term.
And if you’re refinancing things like pre-service debt or federal student loans, know that you could lose some important loan protections. Those might include loan forgiveness, income-driven repayment programs and more.
Peer-to-peer lending pros and cons
Deciding between a traditional bank loan and a P2P loan? Here are some things to consider:
Pros of P2P lending
Here are a couple reasons you might consider a P2P loan:
- Looser eligibility requirements. P2P lending might have less strict eligibility requirements than traditional bank loans. So if you have no credit, have thin credit or are still working to improve your credit, you might be more likely to get approved for a P2P loan.
- Quick turnaround. Many P2P lenders rely on completely automated systems to review and approve applications. And once you’re approved for a P2P loan, you might be able to get your funds in as little as one day.
Cons of P2P lending
Here are some of the potential downsides of P2P lending:
- Higher fees. P2P loans might come with additional fees or higher fees than traditional loans. For example, some P2P lenders charge an origination fee as high as 8% of the loan amount.
- Less support. If you run into trouble paying back your loan on time, you might not get as much support from a P2P lender as you would from a traditional bank. Banks might do things like work with you to create a payment plan. But P2P lenders might not offer that kind of support before sending your account to collections.
- Higher interest. You might find that P2P loans come with higher interest rates compared to traditional bank loans. That might be partly due to the fact that many P2P loans are unsecured. But like many traditional loans, your P2P loan interest rate might be lower if you have a higher credit score.
Investing & peer-to-peer lending
Now you know about P2P lending from the borrower’s perspective. But what do you need to know if you want to become a P2P lender?
Do people make money with peer-to-peer lending?
Lenders can make money with P2P lending. After all, P2P lending is a business. And if people couldn’t make money from it, it might not exist.
But whether P2P lenders do make money—and how much—can vary depending on how much they invest, the loan’s interest rate, the loan terms and whether the borrower pays back their loan.
How much money is needed to start peer-to-peer lending?
There isn’t a specific amount of money you need to have to start P2P lending. Each P2P lending platform might have its own requirements for lenders.
And as with any other financial decision, you should make sure to look at your income, your own debt, your savings, your spending and more to make sure P2P lending makes sense for you.
P2P lending risks
Being a P2P lender can be risky since many P2P loans are unsecured debt. That means there’s no collateral—in the form of property or cash assets—attached to the loan.
Secured debts are generally viewed as a lower risk for lenders than are unsecured debts. That’s because if a secured debt goes into default, the collateral can be taken by the lender. But with unsecured loans, lenders don’t have that option
Peer-to-peer lending in a nutshell
P2P lending might be a good option for some people. But remember: When you take on any kind of debt—or lend anyone money—you should always be aware of the risks and think about the big picture.