Peer-to-peer (P2P) lending is a concept that began in 2005 and is also known as "social lending" or "crowd lending." It was developed to allow individuals to receive direct funding without involving a third-party, like banks or other financial institutions. It is considered an alternative method for raising capital or financing.
P2P lending is a concept that was developed in 2005, making it a relatively new form of lending. Early on, it was seen as a credit offering to people who would likely be declined for credit lines by larger institutions like banks. It was also used as a way to consolidate student loan debt with lower interest rates. Most peer-to-peer lending is now used to consolidate credit card and student debt, home improvement loans, and auto financing. Investors opt-in for P2P lending because it is a way to earn higher interest rates on money than a traditional certificate of deposit (CD), government-issued savings bond, or savings account.
P2P lending is a process of individuals being directly connected to their investors without a bank or financial institution acting as the "middleman." Investors can use various peer-to-peer lending websites to make these transactions with individuals looking to raise capital. Most websites have specific criteria an investor or individual must meet to qualify for P2P lending, with some websites allowing additional criteria input from investors. A wide margin of interest rates are offered depending on the applicant's creditworthiness.
The first step in P2P lending is for lenders or investors to sign up and deposit funds to their portfolio that will be dispersed into loans. Loan applicants then set up financial profiles and are assigned risk categories; this defines the interest rate paid to the lender. Once applicant profiles are posted, lenders make offers to applicants, applicants can either accept or decline offers, and in some cases, they may break the offers up into multiple chunks. This process can be fully automated, or lenders and applicants can negotiate loan terms before agreeing to collaborate. Once an agreement has been met, the financial sums are transferred to the applicant's bank.
Individuals considering joining a P2P lending site as investors should be aware of default interest rates, much like conventional banks. According to the Financial Times, in 2017, Zopa had a default interest rate of 4.52% for loans granted that year. This rate was similar to many other lenders at the time. An S&P/ Experian composite index of default rates across all lending types showed fluctuations between 0.8% and 1% from April 2015 to December 2019. Credit card debt default rates fluctuated much more between 9.1% in April 2015 but hit a low of 3.56% in mid-2018.
Additionally, anyone looking into P2P lending as an investor on a site should review each site's policies on transaction fees and commissions, as sites may charge a commission fee from the lender, the borrower, or both. Each site has its own policy and system for making money.
Another consideration lenders take into account is the possibility of the borrower defaulting on the loan. A default can cause lenders to lose a considerable amount of money if a borrower stops making payments. Unlike a bank account or CD, these investments are not insured or backed by the FDIC. There is also far less liquidity in P2P lending. This investment type is often long-term, as opposed to investing in individual stocks independently or through a brokerage.
P2P lending can be a better option for individuals looking to consolidate debt or obtain financial backing at lower interest rates. It is often a viable solution for individuals with a good credit history. There are the benefits of obtaining funding efficiently online, a single monthly payment, and flexible use of dispersed funds. However, borrowers with less creditworthiness should be cautious.
Peer-to-peer lending doesn't always result in lower interest rates; some APR rates have exceeded 35%. There are also larger limitations on the amount of money a borrower may acquire, and it can be hard to receive more than $40,000 in a P2P loan. Any missed payments on these types of loans can be detrimental to a borrower's credit score and some lending sites may charge high fees in addition to the loan APR.
P2P lending was popularized in China in 2007; however, criticism of the lending model as a pyramid scheme led to a nationwide ban on P2P lending in 2019. The ban was put into effect when companies began struggling to pay back investors due to a lack of regulation within the industry. Many companies would take the money from investors and collect the payments from borrowers but would fail to return capital to the original investor.
What started as just a couple of companies on what was called the "troubled list" grew to over 126 companies in a matter of months, with troubled being defined as "unable to payout investors." China called for all P2P lending companies to register with local authorities by June 2018 to begin the transition of P2Ps being active lenders to serving as informational intermediaries between consumers and insured lenders.
The "pyramid scheme" within the P2P lending in China caused a significant financial upset in the lives of thousands of investors in China. Many investors reported major losses, including one woman who reported that 3.8M RMB was lost to the P2P scandal.
Accounts of major loss forced Chinese officials to step in and impose strict regulations, which caused many lending platforms to go out of business entirely without paying back investors, and with many more expected to fail in the future.
