Definition, How It Works, Risks

• Peer-to-peer lending is a popular alternative to traditional financing methods.
• There are several peer-to-peer platforms to choose from, but not all allow individuals to lend money through them.
• Borrowers and lenders are still subject to risks, such as loan defaults.
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Peer-to-peer (P2P) lending is the process of obtaining financing from other individuals — as opposed to a financial intermediary like a bank or credit union. If you’ve ever borrowed money from another person, you’ve essentially participated in P2P lending in its simplest form. 

You can also participate in P2P lending as a lender, providing funds to loan applicants and earning a return on your investment. So, whether you’re a potential borrower or lender, it’s worth exploring how peer-to-peer lending works and surveying the most reputable platforms that offer this service. 

Peer-to-peer lending basics 

The modern P2P lending system originated in 2005 when Zopa launched in the UK. Shortly after, Prosper and LendingClub brought this service to the US — although LendingClub has since shut down its P2P program. 

Historically, if you wanted to borrow money, you’d go through a bank or credit union. P2P lending cuts conventional financial institutions out of the equation — hence the name peer-to-peer. Instead, an online platform connects an individual in need of money with other individuals and entities willing to lend it to them. In that sense, the lenders are also investors. While this is the basic model, some P2P platforms do source loans through small banks and

credit unions

. 

The P2P lending process can be more advantageous than traditional lending. Some borrowers, especially those with low credit scores or minimal credit histories, may have trouble getting approved for a loan through a bank. P2P marketplaces are often viable alternatives, and they may even provide better rates compared with high-interest credit cards or payday loans. 

For their part, lenders could potentially generate higher interest earnings relative to the yield of a checking or savings account. Similar to the traditional lending model, the borrower makes regular payments, which consist of a principal amount and interest. The interest charge serves as the investors’ profit — the premium they earn in return for loaning the borrower money. However, only institutional investors and accredited investors are eligible to participate in some P2P lending platforms, such as Peerform and Upstart.

How does peer-to-peer lending work? 

P2P lending involves two parties: borrowers looking to obtain financing and investors looking to lend money for a profit. Typically, P2P marketplaces offer fixed rate, fully amortizing personal loans, meaning their interest rates stay the same throughout the loan term and the balance is paid off in equal, scheduled installments. 

Here’s how it works from both perspectives. 

How P2P lending works for lenders

1. First, compare P2P platforms and their investor dashboards. Be cognizant of service fees, as these will ultimately cut into your investment’s return. Once you find your preferred site, create an account.
2. Peruse the platform’s loan listings, which are often organized by some form of credit rating. For instance, Prosper’s rating system ranges from AA to HR, or lowest to highest estimated annual loss on average. Generally, better credit ratings translate to safer loans — but also lower potential returns.
3. Select listings based on loan amount, risk, and potential return. Depending on the size of your contribution, you may have to wait for additional investors to complete the loan’s funding. 
4. Monitor your earnings occasionally. The P2P lending platform will process loan payments and distributions. 

How P2P lending works for borrowers

1. First, compare sites and lending guidelines. Marketplaces can have different origination fees, interest rates, minimum credit scores, maximum loan amounts, etc. 
2. Apply to your preferred platform by filling out their application. This may require a credit check, but some sites allow you to apply for pre-approval — which is a soft inquiry and doesn’t affect your credit scores. 
3. If approved, calculate your monthly payment based on your proposed interest rate and terms. Determine if your payments are within your budget.
4. Wait for investors to review your listing. Depending on investor interest, your loan could be fully allocated within the same day or until your listing expires. For instance, Prosper listings are terminated after 14 days. 
5. Receive funds and start making scheduled loan payments. The amount of time it takes to receive your funds also varies from platform to platform. It could be as soon as one day or several days until your funds are deposited. 

What are the biggest peer-to-peer lending platforms? 

The P2p lending industry has grown increasingly popular. In 2019, the size of the P2P lending industry in the US measured by revenue was $1.45 billion, according to data compiled by IBISWorld. But, comparatively, it’s still only a fraction of the size of the commercial

banking industry

, which came in much higher at $928 billion. 

However, the pandemic stifled lending throughout the country, regardless of industry. Last year, peer-to-peer platforms experienced a sizable decline to $818.5 million of revenue, while commercial banking fell to $836.1 billion. 

The first two major US players were Prosper and LendingClub, both of which offer unsecured personal loans. Although LendingClub pivoted away from P2P lending, additional platforms have since entered the market, including Upstart, SoFi, and Peerform. Prosper alone has issued more than $20 billion of loans since its founding, and Upstart isn’t far behind at $16.7 billion since 2012. 

Despite the relative youth of today’s platforms, the P2P lending industry has a lot of potential. “The recent buzz around decentralized finance shows us the growth potential of peer-to-peer lending,” explains Johannes Larsson, the CEO of Financer.com, an online platform for comparing loans and other financial products. 

“I expect it to not only become more popular in the future but also become the norm one day, as society slowly but surely moves toward decentralization,” Larsson adds. 

Although there are a number of P2P lending platforms to explore, they’re generally more accessible as a borrower than as an investor. For instance, Upstart limits its lending program to accredited investors, who must meet certain financial criteria from an income, wealth, or licensing standpoint. 

Is peer-to-peer lending safe? 

P2P lending platforms are regulated at the state and federal levels. For instance, P2P marketplaces must hold applicable licenses in the states in which they operate. And platforms that sell securities to the public must register with the Securities and Exchange Commission (SEC).

As with any investment, there’s risk involved with P2P lending, especially from a lender’s perspective. P2P lending platforms can have lower minimum credit thresholds than traditional banks, which would indicate higher default risk on certain loans. Some platforms account for this by evaluating loan applicants and calculating credit risk grades. Lower-rated loans may have higher rates of return, but they also carry more risk. 

From a borrower’s perspective, you still may not qualify for a loan. And, even if you do, your loan may not be funded if it doesn’t garner enough investor interest. Further, like traditional loans, P2P borrowers must still make their scheduled payments in full and on time. Otherwise, they risk defaulting on their loan and hurting their credit scores.

The financial takeaway

Peer-to-peer lending can be an attractive alternative to traditional financing and investing. Individuals in need of funds may be able to save money and get approved faster for a personal loan from a P2P lending platform. Similarly, investors could generate additional fixed income by funding loans. 

That said, be wary of origination fees as a borrower and service fees as an investor. They can limit the appeal of P2P lending services. Moreover, keep in mind that you still need to qualify to participate in this kind of marketplace. Loan applicants are subject to a credit check, and individual investors must meet platform criteria, which can have high qualification standards.