What Is a Peer-to-Peer Loan?

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You may have heard of peer-to-peer lending as an alternative way to get a debt consolidation loan or other type of loan. But you might not know exactly what it is. And in fact, most people don’t.

Peer-to-peer lending is a relatively recent development. It’s a new sector of the lending industry that has been growing pretty quickly and whose growth has been helped by the fact that a lot of people are looking for alternatives to traditional loans.

So What is a Peer-to-Peer Loan?

A peer-to-peer loan connects individual borrowers and individual lenders, as opposed to a traditional loan which connects an individual borrower to a large institutional lender like a bank or credit union.

These loans are usually issued by peer-to-peer lending companies that find both the borrowers and lenders and help them connect (the two biggest companies of this type are Prosper and Lending Club). When a loan is issued, the peer-to-peer lending company takes a commission – some percentage – of the loan, which is how they make money.

The companies also break up each loan into many parts so that it can be “funded” by many individual lenders rather than just one. This reduces the risk of default for any individual lender.

What Are the Benefits of Borrowing with a Peer-to-Peer Loan?

Peer-to-Peer loans can definitely have some benefits over taking loans from a traditional banking institution. For example:

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  • You might be more likely to be approved: Because the peer-to-peer lenders have different standards for credit-worthiness, you might be more likely to be approved for this type of loan than be approved by a traditional banking institution.
  • Lower interest rates: This is not guaranteed, but in general you’re likely to get a lower interest rate through these types of loans than if you were to go through a traditional banking institution. If you’re working to pay off debt, then consolidating your high-interest credit card debt with a lower interest peer-to-peer loan could help you get out of debt much faster.
  • Can replace your credit card: This is especially important for people who have difficulty controlling their spending with a credit card. Transferring your balance to a peer-to-peer consolidation loan can allow you to cut up your credit card so you won’t use it anymore.

With that said, here are some things to keep in mind before taking a peer-to-peer loan:

  • You still have to pay it back: This sounds obvious, but just because you’re borrowing from individuals rather than big financial institutions, you still have to pay back the loan on time as agreed in your contract. If you don’t, you could be subject to the same consequences as any other loan (debt collections, damage to your credit score, etc.)
  • It shouldn’t be used as a way to increase debt: Again, this might sound obvious, but if you use a peer-to-peer loan to pay off your credit card, then you shouldn’t continue spending on the credit card afterward. That would mean two debts instead of one, which is recipe for disaster.
  • The terms might not be better than a traditional loan: Just because peer-to-peer lenders can often offer better interest rates, that doesn’t mean they do in every case. You should do your research before taking any loan to make sure you’re getting the best deal and that the terms of the contract are fair to you.

What Are the Benefits of Lending with a Peer-to-Peer Loan?

There are some real benefits to being a peer-to-peer lender, as well, if that is something you’re interested in:

  • You can earn a good interest rate: Since these loans are between individuals, you are able to make a solid return on your investment (the only “middle man” in this case is the peer-to-peer lending company, which takes a small commission as mentioned above).
  • You can invest only a little: These companies accept investments from individual lenders in whatever amount you want to invest. There is usually no minimum amount, which means you could start off investing as little as $25 or $50 if you’d like.
  • You can choose safer loans if you want: The companies also make it possible to choose between loans that are safer (with slightly lower interest rates) and loans that are riskier (with slightly higher interest rates) so that you can choose the amount of risk that’s comfortable for you.

If you’re curious about becoming a peer-to-peer lender, there are a few things you should know first:

  • It should be viewed as an investment: Just like other investments, there are no guarantees that you will make money (or even get your money back). For that reason, it’s important to be very cautious and research the risks in addition to the benefits, before
  • Your level of risk affects your earnings: As mentioned above, you get to choose from different interest rates and people to lend to. Just like a bank will offer various interest rates depending upon the applicant’s probability of paying back a loan, the interest rate you will receive will be higher for riskier applicants, and lower for less risky applicants.
  • You can mitigate your risks by having a portfolio: You can mitigate your overall risk of default by lending to many individuals at the same time instead of lending one large lump sum to one or two individuals. That way, if there are defaults, the hit won’t be as bad.
  • Remember that lending platforms earn money too: Lending platforms earn their money by taking a percentage of the originating loan cost for each loan.

Hopefully this has helped answer the question “What is a peer-to-peer loan?” Whether you are interest in being a borrower or a lender, there is great potential with peer-to-peer loans, but as with any investment or loan, it’s crucial that you do your research ahead of time so you can make a decision that is right for you.

Have you ever used a peer-to-peer loan? Share your experience with us in the comments below.

Image Credit: Luigi Anzivino

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  • shannon

    I used Prosper five years ago to payoff a credit card that jumped to almost 30% for no reason except for the fact it was 2009. I got a much lower rate (around 10% I think) and I paid it off early (it was a three year note). Agree that the key is not acquiring more debt; it was a great tool for me on the path to debt free. I also liked knowing my monthly payments and interest were going to individuals who put trust in me, not an institution. It saved me a lot of money in interest fees!

    • Wow, that’s great! I’m glad to hear it worked out well for you. And I agree – it’s nice to know your payments are going to a person who had faith in you rather than a large institution. Would you be interested in sharing your experience for a future post on our blog? If so, let me know! Thanks.

  • Francisco Javier Thayer

    Is there any way to quantify and estimate the quality of a particular loan?

    • I’m not sure if I understand your question fully, but yes, you can definitely compare things like interest rates to determine the quality of a loan offer.

      • Francisco Javier Thayer

        What I meant is from the point of view of the lender…what is the likelihood that a borrower might default and how if at all can the lender estimate it. Or put another way what is the vetting process for borrowers?