What is Peer-to-peer lending?
Peer-to-peer lending (P2P) is a relatively new form of debt financing. It is a type of crowd-funding that addresses the needs of both – people who want loans and those who want to invest. P2P allows people to borrow and lend money without the help of an official financial institution. So, it eliminates the middleman from the process, thus leading to lower costs.
A common platform or marketplace that connects these borrowers to investors is called a P2P platform. Normally, peer-to-peer lending uses an online platform, where lenders and borrowers have to register themselves. The concept behind P2P lending is that savers get relatively higher interest by lending their money instead of saving. And, borrowers get hassle-free funds at comparatively lower interest rates.
How to get started?
There are mainly three steps to start with the P2P lending;
- First, you will have to open an account with a P2P and pay the pre-determined charges.
- Second, set the interest rate or agree to the current rate.
- Third, you can now start to lend or borrow. Lending usually involves paying a small fee to the P2P platform (like 1% of the loan amount).
Peer-to-peer lending is a relatively new form of finance that hasn’t been tested over the long term. So, some unexpected issues might crop up at any time. Investors, therefore, are advised not to put all their assets into the P2P model. Also, they must carry out extensive research while selecting the best P2P platform and the borrower.
Why go for P2P lending?
P2P lending ensures a regular flow of income for a lender, which might exceed the interest they would have earned from other saving instruments, like Fixed Deposit, Recurring Deposit, and more.
For the borrowers, P2P lending is an easy source of finance. Borrowers get attractive interest rates and almost instant access to the loans as there is no paperwork involved.
How does peer-to-peer lending work?
In the traditional banking system, the people who need loans approach banks. The bank then carries financial checks on the applicant’s credit history and, if satisfied, extends the loan after extensive paperwork. However, those with poor credit history may not qualify for a bank loan. Even if they qualify, the bank will charge a higher interest rate from them.
To avoid such higher interest rates and get a loan easily, such borrowers may go for peer-to-peer lending. In P2P, borrowers take a loan from the investors who are ready to lend at an agreed interest rate. Lenders have access to the borrower’s profile on the P2P platform. This helps them to decide if they want to lend money to a particular borrower or not.
Further, it is up to the lender to loan the full amount or only a portion of the asked amount. If a borrower gets a partial loan, they may approach another lender on the platform for the balance amount.
Borrowers and lenders enter into an agreement after finalizing the loan amount, interest rate, and repayment terms. P2P platforms facilitate the transactions but are not responsible for the default beyond their policies.
Risks associated with P2P lending
Peer-to-peer lending can be risky, and thus, it is very important that lenders understand the risks associated with it.
There are always chances that the person to whom you are lending fails to repay. It must be noted that the money lent via a P2P platform is usually not covered under any law. However, many P2P platforms maintain contingency or provision funds to pay the lender if a borrower defaults. Also, some platforms help the lender initiate legal actions against the defaulting borrower.
P2P site going bust
Since P2P is mostly an online phenomenon, there is always a chance of the platform going out of business. In such a case, you may lose all your money. However, many countries have regulations in place to force the platform to keep lenders’ money separate from their own money.
Your cash may not be lent straight away
You are not entitled to any interest on the cash waiting to be lent out. To avoid such a scenario, you must go for easy terms to attract borrowers.
Advantages of P2P lending
- Opportunity for lenders to earn attractive interest rates.
- P2P platforms help you spread your risk by allocating capital to multiple loans.
- If borrowers default, most P2P platform assists with legal actions and even reimburses lenders.
- For borrowers, P2P lending is easy to access to the funds.
- Many P2P platforms allow you to liquidate your funds even before the end of the term. This helps you, in case you have some urgent requirement of money.
Disadvantages of P2P lending
- Unlike the traditional saving, the money in P2P lending is not secured by Government’s guarantee. However, different countries have different rules regarding it.
- You will need to pay a fee to the P2P platform each time you lend the money.
- Interest earned on the P2P loan is taxable. But, you can consult a tax expert to help you lower your tax liability.
Read more about other Sources of Debt Financing.