How Peer-to-Peer Lending Works

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Peer-to-peer lending connects consumers directly to investors offering loans, thereby cutting out the middleman of a bank or other lender. Peer-to-peer (P2P) lending marketplaces such as LendingClub and Prosper make it easy for individuals to access loans without relying on a third-party financial institution.

This approach to borrowing can be beneficial if it provides better rates on a loan, but it’s still worth shopping around with a few lenders to find your best loan that’s most suitable for your needs.

Let’s answer the following key questions about peer lending:

What is peer-to-peer lending? How does peer-to-peer lending work? How do you apply for a P2P loan? What are the pros and cons of P2P lending? Is P2P lending right for you? What is peer-to-peer lending?

Traditionally, if you needed a loan, you would head to a bank or other financial institution to see how much money it would let you borrow. In the P2P lending system, loans are given online directly by individuals, investors or businesses.

Each lender will have its own stipulations on the amount you can borrow and the purpose of the loan, and you’ll need to go through an application process.

How does peer-to-peer lending work?

Peer lending works by applying for a loan on a P2P marketplace website such as LendingClub. Investors on those platforms then offer to lend you money under certain repayment terms.

The platform assesses your risk level using factors such as your credit score. Your creditworthiness will determine your interest rate and loan options, often in a matter of minutes.

The investors simultaneously present their loan offers for you to choose. Once you pick your loan, the lender will send funds directly to your bank account. You then make monthly payments to repay the loan under the agreed-upon timeline and interest rate.

The loan might be funded in a day or a few weeks. There’s typically no penalty if you repay early to get out of debt faster and save money on interest.

Unsecured personal loans are the most common P2P loan type. You can typically use the money to buy a new car, make improvements to your home, consolidate credit card debt or fund a new business venture.

How do you apply for a P2P loan?

The application process for a P2P transaction takes place online and usually can be completed in minutes. The process will vary depending on each lender’s requirements for different types of loans.

To borrow money, you usually need to be at least 18 years old, have a valid Social Security number and bank account. You will also need to provide personal information such as your birthdate and address. For certain types of loans, like the ones below, you may be asked to provide other data.

Personal loans. A lender could consider your credit score, debt-to-income (DTI) ratio, employment status, salary and other financial factors to determine your eligibility and interest rates. The P2P lender might also want to know the reason you need the loan and ask for additional information, such as your outstanding debt, mortgage payment and education history. Business loans. A lender could ask you to provide information on factors such as the amount of time you’ve been in business, your personal and business credit scores, revenues and profits, tax returns, balance sheets and your debt service coverage ratio, which is a measure of business cash flow. What are the pros and cons of P2P lending?

Like any financial product, peer-to-peer lending has a number of potential benefits and drawbacks for consumers. Here’s a quick rundown of each side of the P2P coin:

Pros of P2P lending Potential for lower interest rates. The P2P marketplace is competitive, so you could potentially secure interest rates that are lower than those at a bank or other financial institution. Also, the transaction happens between two individuals, so all the interest goes directly to the investor, who has less overhead, so they can charge lower rates. Simple and fast process. The application process typically takes a matter of minutes, and you’re presented with options just as fast. Then, the funds can be deposited directly into your account in days. Poor credit doesn’t necessarily disqualify you. Although P2P lenders take your credit score into consideration, they might be more forgiving with your credit history. You likely will face higher interest rates with a poor score, but your application might not be rejected. Debt consolidation and refinancing. If you have high credit card debt, you could face an APR of over 20.00%. A P2P loan with a lower interest rate could be a good option to pay off the debt. This also might help in case you’re looking to consolidate or refinance other types of high-interest loans. Fixed monthly payments. P2P loan repayment plans typically have fixed rates, so your monthly payment remains the same, enabling you to budget your finances properly. No prepayment penalties. You don’t face penalties for paying off your loan early, which can help you save money spent on interest charges over time. Cons of P2P lending There may be fees for borrowers. LendingClub personal loans, for example, come with an origination fee of 2% to 6% of the loan amount. That may be higher than the fees you’d find on personal loans from a bank. Interest rate could be high. Although some lenders might offer a lower interest rate, others might charge a much higher rate than on a personal loan from a traditional source. That’s why you should research and consider multiple sources while borrowing money. Lack of regulation could hurt. Although P2P companies are trying to offer customer protections, the industry itself is relatively new and therefore prone to problems arising from lack of regulation. This can put both borrowers and lenders at risk. Service not available everywhere. Not all states allow P2P lending, so double-check to see if it’s available for you. Is P2P lending right for you?

If you’re looking for a loan to pay off credit card debt or finance a big purchase, a P2P product might be a fast, easy and cost-effective option. But just like when applying for a private student loan or a personal loan, it’s important to understand how peer lending works and consider offers from multiple lenders to find your best rates.

A lack of regulations for the relatively new marketplace of P2P lenders could mean that borrowing from a traditional lender could work better for your financial situation. Evaluate the pros and cons before making a decision and make sure you have the funds to pay back any loan you take out.

Rebecca Safier contributed to this report.

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