How Does Peer to Peer Lending Work?

Obtaining financing is often a challenge, banking institutions often set high standards of eligibility, usually leaving out of this range of application people who, although they don’t have bad credit or a perfect recent history, are not eligible in their opinion.

Because the economic system doesn’t wait for anyone, many have had to turn to alternative lenders to, for example, make a home repair, buy a car, get an education loan, and deal with a medical emergency, among other things.

One of the available options is peer to peer (P2P) loan systems.

These, often are based on a system called crowdfunding –Where you have a network of potential investors who are more likely to approve your application, and often at a rate that actually competes against other financing methods.

But this is not in all cases, in this article we will explain to you in detail how P2P or peer to peer lending works and all the details that you need to know if you want to get a share of it.

What is a peer to peer loan?

Essentially these P2P loans are those that individuals and investors make, and it is expressed in plural because it is often about collective financing, differing from loans that come from your bank.

That is people with extra money who want to make a profit offer to lend that money to individuals and businesses, almost always through online platforms or banking systems.

A P2P service (usually a website) is one similar to a central market, confronting lenders with borrowers, making the process relatively easy for all the elements involved in this economic activity.

Each investor can view and select the loans they want to finance, and these loans are most commonly used as personal loans or small business loans. Companies that make peer-to-peer loans are commonly called peer-to-peer lenders or market lenders.

How does this system work?

To apply for a P2P loan you must first choose a lender and complete the application process.

As a general rule, you will need to provide details such as name, social security number, copy of identification, among other personal data, and the lender may sometimes ask what purpose you have in mind for the money.

Usually, the lender will check your credit score and, if you are eligible for the service, the investors will finance the loan.

With some lenders the financing process is fast, but it can also take several days or a few weeks.

Then, if the loan is approved and financed, you receive the money electronically and pay it off with automatic electronic payments.

Repayment usually involves a period of three to five years, but you can almost always pay upfront with no penalty, which helps save money on interest.

When applying for personal loans, you should also provide information about your home or mortgage payments (whichever applies), other outstanding debts, work status and salary (personal balance if you’re self-employed), educational history and details about the loan you’re looking for.

You may also need to verify some of that information through a photocopy of identification, pay stubs, or W-2 forms.

  • When it comes to commercial loans, it’s normal to provide information about your company’s financial data, and you may need to submit important documentation, such as:
  • Tax returns.
  • Balance sheets and profit and loss statements.
  • Business credit score time (personal and business).
  • Debt service coverage index.
  • Income and profits.

Requirements to be a lender

In the same order of ideas, certain requirements must be met to participate in these platforms, as market lenders impose restrictions on what types of people can invest in their loans.

Some companies are open to all those who have economic resources for this activity, as long as they meet the minimums of the account, but most companies in this industry can only be open to reputable investors or qualified buyers.

Accredited Investors:

You are considered to be so when having a personal income of $200,000 ($300,000 for joint ventures) over the past two years –You can also qualify with a net worth greater than $100,000,000, either individually or jointly.

Qualified buyers:

Must meet higher requirements than reputable investors, having at least $50,000,000 in investments.

On the other hand, some market lenders only allow institutional investors, such as hedge funds, commercial banks, pension funds or investment funds and life insurance companies, as colleagues.

In the next points, we are going to take a look at the pros and cons of dealing with P2P loans in from both positions.

Advantages and disadvantages as a borrower

As a borrower, the main advantage is that the process is more standardized, and therefore there is a wider chance in which you will qualify for the loan. But there is more:

Advantages

  • An online application is usually simple and quick.
  • Interest rates are traditionally lower than banks.
  • Fixed monthly payments.
  • Unlike other methods, you can consult the rate without affecting your credit score.
  • The requirements are usually less stringent than in a bank.
  • You can expect the most loans to be unsecured.
  • Flexible use of funds, in contrast to the rigid requirements of banks.
  • Automatic repayment.
  • No prepayment penalties because the lender wants your money back fast.

Disadvantages

  • Possible interest rates of up to 36% if you have below-average credit, although you can’t expect competitive offers with bad credit.
  • You may qualify if you have a credit score below 630 points.
  • Generally, the maximum amount you can borrow is in the range of $35,000 to $4,000.
  • Some of these online businesses have high fees, including origination fees of up to 6%.
  • Lost payments will damage your credit score.

Advantages and disadvantages as an investor

In the same order of ideas, investing in loans isn’t always safe, and given to the standardized nature of these loans, often you will be giving money to people who you wouldn’t lend to in another type of contract. But there is more to be said:

Advantages

  • You get a higher return than savings accounts or CDs.
  • You enjoy access to alternative investments outside of stocks and bonds.
  • Most platforms allow you to automatically diversify your loan portfolio and therefore increase your client portfolio.
  • Sense of social or community wellness by lending directly to your peers.

Disadvantages

  • Risk of losing your money in case of default by borrowers, as there are mostly no guarantees.
  • It is not insured by the FDIC as if it were a savings account or CD.
  • Less liquidity than stocks or bonds because of long-term horizons (three to five years repayment).
  • A relatively new industry could mean more instability.
  • Some sites are only available to reputable investors.

Is it P2P lending safe?

While this factor will depend on what each platform is doing about it, most conventional lenders are relatively consumer-friendly and strive to meet all needs, this being a very important one. We can mention three highlights:

Data:

P2P’s most employed lenders keep your information as secure as any other financial institution, all communication between you and them usually takes place through an encrypted browser session.

Privacy:

Your identity is almost always kept secret from individual lenders, but you will need to review the privacy policies to understand what information investors receive. Remember that institutions have the right to share information.

Rates:

Interest rates are often competitive compared to other loan acquisition systems, in fact, it is very likely that you will pay less than you would pay for a payday loan.

However, interest rates may increase on variable-rate loans, which increases your payment.

Other things to keep in mind

Every time you repay a loan within the conditions you are building your credit, and in this case, most of the lenders report your activity to the big credit agencies, which will help you to obtain loans with better conditions in future occasions.

On the other hand, if you pay late or fail to repay the loan, your credit will be a bad reflection of that, so take your payments seriously and contact your lender if repayment becomes difficult.

It is common for you to have to pay an origination fee of between 1 and 6 percent to finance your loan. The percentage applied depends on the amount you borrow, for example, a $1,000 loan could include an origination fee of $60.

It may seem like too much money compared to the rate the bank would charge, but keep in mind that a poor rating or second mortgage wouldn’t be far from this percentage.

To Sum Up

No option should be ruled out when an emergency arises, a unique business opportunity presents itself, or you invest in your education and a better future.

Although you cannot count on the conditions to borrow money from the bank, you have a range of alternatives to achieve your goals, including peer to peer loans.

Remember that if you have good credit, P2P loan rates can be conveniently low, even with less than perfect credit.

Besides, don’t forget that they are long term loans (3 to 5 years) and that before accepting one you have to analyze if your current condition allows you to assume that commitment.

Preferably choose those platforms with a good reputation, whose users are satisfied with the service.


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