Making Money from Lending Money: Peer-to-Peer Lending 101

Most likely since as long as money has existed as a medium for exchange, people have been lending and borrowing money for one reason or other. People have been making a profit out of lending money for just as long too. 

You have probably seen it in TV shows or movies where a hapless character has no other choice but to borrow money from an unscrupulous and cutthroat entity to pay off their debt. Little does the desperate character realize the trap they have unknowingly walked into where the money lending entity makes it impossible for the borrower ever fully to pay back their loan. Suffice it to say, both for those looking to lend money and borrow it, Hollywood has not painted it in a favorable light. 

Fortunately, in real life, things are not nearly as dramatic as that. Lending money is not this suspicious or theatrical means of making a profit. It is very professional and has become very modernized. While it is true that, just like with every kind of ventures dealing with money, lending has its risks and uncertainties. However, as a whole, if you are equipped with the right knowledge and resources, money lending can be quite lucrative.

Now you might be wondering: how can anyone possibly make any money from lending money? Does not that sound a little bit contradictory? If anything, would not someone stand to lose money by just lending money to people? Well, for aspiring investors out there, let us talk about peer-to-peer lending. 

Peer-to-Peer Lending

Peer-to-peer (P2P) lendingis a relatively new method of debt financing that matches astute lenders with creditworthy borrowers without the use of a traditional financial institution (commercial banks, investment banks, stockbrokers, etc.) to act as an intermediary. Because P2P lending removes the need for a middleman in the lending process, the lender and the borrower get a much better deal. The lender benefits from greater returns while the borrower receives extremely competitive and flexible personal loans. 

This method is also known as social lending or crowdlending. 

Brief History

Lending and borrowing money is not a new concept. People have needed to borrow money for personal and business reasons for centuries, but typically they would have to approach a financial institution for a loan. And it is not guaranteed that one could get a loan since the application process is intensive and notoriously imprecise. 

Financial institutions like banks run extensive financial checks on the applicant’s credit history so they can determine if the applicant is qualified for a loan. If the applicant is deemed eligible, the bank then determines the interest rate that will be charged on loan. This method is inconvenient and, at a time, discriminatory as individuals with poor credit history stand no chance of ever getting a loan no matter what. 

Borrowing from individuals rather than entities is one alternative to getting a certain loan. However, this informal method bears inherent perils since no intermediary is making sure that the borrower can and will pay back the lender. And that is how the peer-to-peer lending industry started to gain popularity

In the United States, P2P lending became formalized more than an eleven years ago when lending platforms like Prosper and Lending Club were launched. Not without some scrutiny from the Securities and Exchange Commission, of course. SEC had to carefully examine the P2P lending platforms, to make sure that they were not out to scam potential clients out of their hard-earned money. Thus, the two companies were subjected to an expensive, arduous, and time-consuming registration process. 

Many did not believe that the emerging lending platforms were not going to survive, but they did and, not only that, they have flourished. More P2P lending platforms followed suit. 

Typical Characteristics of Peer-to-Peer Lending

prior relationship between the lender and the borroweris not required. While this has some obvious disadvantages (not a lot of people are thrilled to give strangers a significant amount of money), it can work to your favor. Because there is no familial or friendly bond between you and the borrower, you will ultimately only ever view the process from a business standpoint.

P2P lending is mostly conducted for profit like a budding entrepreneur who wants to fund their project but does not have the adequate resources. In this respect, P2P lenders are investors as well. 

While there is no commercial or investment bank (or other entity) that mediates the process, there is a P2P lending company that will bring lenders and borrowers together. These companies offer lenders a greater chance of high returns than what they would have gotten with traditional financial institutions.

The whole transaction is done online. P2P lending platforms operate online which allows for more people of all walks of life access to more financial opportunities.

While P2P loans can be secured or unsecured – which means it is either protected by a guarantor (or come with collateral) or not – they are generally not secured by government insurance. However, some companies outside the US offer protection funds.

Depending on the P2P lending company, lenders can choose which borrowers to invest in. 

How Peer-to-Peer Lending Works

Though P2P lending is much more organized and sophisticated than, say, loan-sharking, the idea behind it is pretty simple. You, the lender, loan money to borrowers who are required to pay you back with a certain interest. In the case of P2P lending, the lending platform gets a cut of the interest.

The P2P lending company is responsible for collecting loan offers, screening only creditworthy borrowers, and allocates the loans appropriately. The company is the middleman that facilitates the actual lending. In some companies, lenders and borrowers are kept anonymous for peace of mind. A lender’s money is generally lent to more than one borrower, to ensure the lender maximum returns.

Lending 

The first thing a lender needs to dois to create an account to the lending company of their choosing. There are several reputable P2P lending platforms to choose from, and it is advised to do thorough research before settling on a single company. Once you are signed up, you then need to decide how much money you are willing to transfer to your lending account. Of course, your money will not be lent out without your full consent. To start lending, you need to make a loan offer.

The sum of money you agree to be loaned will have to be available for a set amount of time. Most investments are one to five years. The agreed upon a number of years will allow the company to make your money work as effectively as possible. If things go according to plan, then you will be able to to see a return on your investment that is greater than on any offer from savings accounts. 

Generally, making loan offersis rather straightforward. Once you have transferred your money to your account, all you need to do is decide how much you want to lend and for how long. The P2P lending company will then find the adequate borrowers looking for a loan of the same timeframe. If ever you wish to cancel your loan offer, you withdraw that amount but be aware of the fees you will have to pay to do so. The fee will depend on the company and how much money you will withdraw. 

Repayments 

It largely depends on the P2P lending company how often and how much lenders are repaid each month. Some companies offer several repayments in every month while others might only offer once a month repayment. 

Repayments are directly transferred to the lender’s account and will be made available either for withdrawal or re-lending to new borrowers. It is often advised by the company for lenders to keep reinvesting their money for maximum returns. If you only keep your money in your account, it will not generate you any profit.

Additionally, borrowers can choose to overpay or settle their loans early so lenders will receive them before the loan period is over. 

Borrowing

People who take loans from lenders are called borrowers. Borrowers are individuals who are in need of a certain amount of money for some reason or other. They sign up in P2P lending platforms to borrow money from individual investors for an agreed upon interest rate.

Most, if not all, P2P lending companies make sure that the borrowers are legitimate and creditworthy. They must confirm that the borrowers are fully able to afford their loan to avoid default on their loans. To avoid individuals from deliberately attempting to swindle the system, P2P companies need to be thorough in assessing the borrower’s profile. 

A borrower could receive the full loan amount or just a portion of what they requested from investors. This depends on the company. Of course, most loans have multiple sources, so it also depends on how much the borrower requests from the company.

In P2P lending, borrowers have better access to financing that they may not have otherwise gotten approval for from standard financial entities. Moreover, borrowers get a more favorable interest rate on their loan, an amount that they are confident that they can pay back after a certain amount of time. Traditional financial entities are not so accepting or accessible. They charge outrageous interest rates that could financially ruin a small start-up company.

P2P Intermediaries

Peer-to-peer lending platforms are for-profit companies that provide an avenue that matches lenders and borrowers. Entrepreneurs and businesses that are in need of funding (either for minor or commercial projects) have to file an application form with these P2P lending middlemen. These online intermediaries asses the borrower’s credit history, check their credit risk, determine a credit rating, and decide an interest rate to the borrower’s profile. The repayments from borrowers are done through the P2P companies which then forwards the payments to the lenders.

Since peer-to-peer lending rose to prominence over a decade ago, numerous P2P platforms have emerged. Lending Club, one of the first P2P companies, is considered the world’s largest P2P lending platform. 

Essentially, P2P lending companies aim to facilitate the process of lending and to borrow money to ensure that controls are in place. These companies make the process as straightforward and painless for everyone involved. Some platforms allow lenders to see the borrower’s profile themselves, so they will personally know what kind of individual is borrowing their money. Others keep both parties in the dark the entire process since anonymity will avoid certain inconveniences. 

However, while it is true that P2P lending has overcome initial backlash and has thrived over the years, not everyone can participate in this process. Some countries have strict regulations regarding lending. In the US, certain states do not allow investing in P2P platforms. It is important to keep in mind that peer-to-peer lending is not allowed everywhere, so you need to check whether your country or your state permits this kind of lending before registering to any platform.

Why Peer-to-Peer Lending is Popular

Since Prosper and Lending Club launched more than ten years ago, P2P lending has seen rapid growth. However, its success does make people wonder why it’s getting the popularity that it has. Even Wall Street titans have praised P2P lending as a worthy investment. 

Here are just a few basic reasons why P2P lending is so popular:

People want to escape the trap of credit card debt

One of the most common types of loans borrowers apply for in P2P lending platforms is debt consolidation. Usually, consumers have no choice but to consolidate all their credit card payments on one credit card, lumping all the debts into a single payment.  However, by doing so, people can find themselves in big trouble quickly. If a borrower misses a payment on their credit card debt, rates will keep on increasing (upwards to 25% in some cases) until it comes to a point where the consumer will find it harder and harder pay each month. 

With P2P lending, on the other hand, borrowers can get a typical three-year loan at a modest interest rate and eventually free themselves from credit card debt. 

Standard financial institutions do not lend freely

Banks are not the easiest entities to borrow from. Personal loans are impossible to obtain these days. Small businesses also get a hard time borrowing from the bank. These businesses often have to search for alternative sources of funds since bank loans are so difficult to get approved.

Individuals and small businesses – granted that they have decent credit – can easily apply for a loan on P2P lending platforms. They will have more financial opportunities with P2P lending, and they will not have to worry about rising interest rates. 

P2P lenders can earn greater returns

Those who lend in P2P lending platforms are often considered investors since they have the chance of making a profit from their money. Just like investing in financial securities like stocks and futures, P2P lending can offer big returns if all goes well. Of course, just like with any investment, there are risks involved, but that is already a given. Interestingly enough, some lenders are even earning more in P2P lending than in traditional fixed-income investments.

Institutional investors are now getting into P2P lending

A few years after P2P lending companies established themselves, some institutional investors started moving significantly large amounts of money in the platforms. Hundreds of millions of dollars have been invested in these P2P lending companies, and the numbers continue to grow. This, of course, is great news not only for the company but its borrowers and lenders. 

P2P lending is now a recognized, credible source for investment

Though the industry had to fight hard to prove naysayers wrong, P2P lending is now a thriving industry that trusted investors and personalities even recommend pursuing. In its infancy, P2P lending was considered by many to be merely a passing trend, an industry that can’t possibly hold its ground in the modern market. However, years later, P2P lending platforms continue to grow and improve. Wall Street giants have even joined the board of certain P2P lending platforms, further proving that the industry is one worth investing. 

The Risks and Shortcomings of Peer-to-Peer Lending

As stated multiple times, there is a chance you can get bigger returns from P2P lending. However, like with every type of investment, nothing is completely guaranteed. Loaning your money to a P2P lending company comes with it certain risks that you can’t avoid, no matter how much research you do and how much restraint, and patience you have. Even with the numerous safeguards, P2P companies put up, and some investment risks just can’t be avoided, so the best thing to do is to understand the risks and shortcoming involved 

Vagueness in how the company handles your money

Most of the time you do not truly know how the P2P lending company handles your money. You are given a general explanation of how the process is going to work but, for the most part, the company will not disclose the details surrounding how they manage lenders’ money. 

It is typically not a good idea to assume all platforms are trustworthy. For a lot of serious investors, this obscurity can be a bit off-putting. When the P2P lending platform processes the transactions, you do not know how the company accesses the money and then distributes it to borrowers. 

You are putting your money at quite a risk when you do not know what goes on behind the platform. Worst case scenario, the company could just run off with all the cash the lenders invested in the company, and you would not know about it until it is too late.

Cybersecurity threats

Nowadays, cybersecurity is more important than ever. Hackers are now more skilled, astute, and relentless. And since P2P lending companies involve large financial transactions, they are incredibly attractive targets for hackers. The company and all of its lenders could lose everything in a matter of seconds if they are not careful. 

Moreover, your invested money is not the only thing you risk. When you become a lender, you are required to post sensitive personal information to authenticate yourself. If a P2P lending company does not have a strong enough cybersecurity, your private data could also be at risk. 

Borrower default

There is always the possibility that a borrower will fail to pay the interest that was agreed on. Even if the P2P lending company can boast that they only accept prime borrowers who have demonstrated that they can pay back the loan fully, unforeseen circumstances could occur that will force the borrower to default on their loans. Health issues could pop up, rendering the borrower physically incapable of working to pay off the loan. The borrower could also suffer an unexpected loss of employment, or perhaps their business will not turn as much profit as needed. No one can truly predict what happens. 

Borrower defaults have a negative effect on the returns the lenders receive. Also, if a borrower can’t meet their obligations, they will have to restructure their debt. For lenders, this could mean an extended time period to get full returns.

Cash drag effect

Inevitably, there will come a time when the number of investors will significantly outnumber the potential creditworthy borrowers. This is called the “cash drag” effect, and all financial institutes have to deal with it no matter how many precautions were taken.

When you transfer money to the P2P lending platform and make it available for loan, you can only earn in interest if your lending offers are matched to a borrower looking for a loan over the same term. And since P2P lending has gotten so popular, a cash drag is unavoidable. 

Conclusion 

P2P lending may still be a considerably new organized industry, but it is not going away any time soon, especially nowadays when people are much more open about giving alternatives to traditional financial institutions a try. While it does have its fair share of risks, it also offers ample opportunities for profit.

Ultimately, when considering P2P lending, it is important to remember an important rule in investing: do not invest more than you can afford to lose.