Peer-to-peer lending, or P2P lending, is a type of loan financing that cuts out the middleman. Instead of applying for loans from banks or other financial institutions, individuals can instead fund their mortgages or different needs directly from other individuals.
Reducing intermediaries reduces costs, and increases transparency and efficiency. There are risks when it comes to raising money from complete strangers, but that’s why there are platforms that facilitate the process.
Also known as crowdfunded loans, this type of financing has become increasingly popular over the past few years. But does that make it any less risky? Let’s find out…
How Peer-to-Peer lending works?
Within a P2P lending platform, borrowers get direct access to private investors (lenders) instead of going through a traditional bank or credit institution. Investors want a return on their money, so they’re looking for lucrative interest rates. The borrower is looking for conditions different from traditional lending. In theory, both parties benefit from the arrangement (though we’ll get into the details later).
Risk factors, cost & repayment terms in crowdfunded loans
Crowdfunded (peer-to-peer) loans can be secured or unsecured. They are raised from a number of individual lenders, usually online, and the borrower (individual or business) should repay the loan directly to the lender, as per the agreed-upon terms.
This unlocks a whole plethora of considerations that you should have in mind when using P2P lending as a borrower or as a lender (investor).
Fixed interest rates: Many crowdfunded loans offer fixed rates of interest, which means that the repayment amount goes in steadily. This is a good option if you, as a borrower, want to plan your monthly repayments in advance.
Variable interest rates: Some P2P lending platforms offer flexible or variable interest rates and charges. This means that your repayments could change according to changes in the central bank interest rates or other factors.
Sometimes borrowers need to pay higher rates because lenders are taking on more risk-lending money outside of normal banking channels; this is known as ‘interest rate risk’.
The best platforms offer competitive interest rates that compare favourably with other mainstream borrowing or investment options such as high street savings accounts, term deposits or portfolio management companies.
Some platforms only allow investors to lend money for short periods (e.g. 6 months), while others allow people to lend for longer periods (e.g. 5 years). This is important because it determines how long you will have to wait before you can use your money again and whether you will have time to reinvest any returns before you need to withdraw them from the platform.
Different platforms lend money to people or businesses who have a higher or lower risk of defaulting on their loans. This is why you, as an investor, should carefully consider the ‘default risk’ because you don’t want to lose some or all of your money.
Secured (collateralized) loans: One way for lenders to make sure they get their money back is by accepting collateral. Property developers can submit the land or building as collateral, and in case of default, lenders will be able to get their money back (later) after that land or building is repossessed and sold.
Unsecured loans: These are usually personal loans of smaller amounts. People (borrowers) use their credit score/reputation to convince the lenders they will be able to repay the loan as agreed.
P2P lending platforms who are in the business or unsecured personal loans will usually offer the so-called buyback guarantee – credit originators buy back bad loans and start a collection process. Insurance might also be present but not very common.
The best lending platforms are transparent about how they operate, including what they charge and what risks they take on – and they explain changes to these charges in plain English. They should also be able to demonstrate a track record of successful lending and help investors understand the reasons behind any defaults.
Cashing out P2P investment earlier than planned
Cashing our your crowd loan investment earlier than the investment term means you should sell it to someone else. This is exactly the reason P2P lending platforms should offer the so-called ‘Secondary marketplace’ where you, as an investor, can exit your position.
Some platforms might not have a secondary marketplace but they do charge fees if investors ask for their money back before the end of a loan term (known as an ‘early redemption fee’). These costs may reduce any returns you make from your investment.
Other platforms charge fees if borrowers don’t repay their loans on time (known as ‘default fees’), ensuring investors are better protected.
P2P lending platforms: Safety and security measures
Safety and security are the most important factors to consider when investing in an online P2P loans marketplace. Below are some of the measures that investors can expect to see in a reputable P2P lending marketplace:
Historical performance & reputation of the platform
Before investing in a P2P loan platform, you should take time to research its reputation. You can do this by checking customer reviews, reading news articles and investigating lawsuits or complaints against the company. Look for platforms with a good reputation that have been around for a few years.
We’ve curated a list of platforms and their historic returns in another blog piece.
The best platforms will offer two-factor authentication and SSL encryption as standard features on their websites. This helps protect your personal information from hackers, who could use it to steal your identity or try draining your investment account if they could gain access to it.
Don’t worry – this is very unlikely to happen because a P2P lending platform should not disburse funds to an account with a different account holder’s name.
Should you lend your money via P2P lending?
For the vast majority of people, investing in P2P lending is a sensible financial decision for several reasons. You’re likely to earn a good return with low risk compared to other options, which makes it worthwhile:
- It’s essential to remember that peer-to-peer lending is not risk-free and returns are not guaranteed. You should never invest more than you can afford to lose and always do your own research before deciding whether or not to invest through any platform.
- Investors who are considering peer-to-peer lending should read the FCA warning about the risks of peer-to-peer lending.
The future of P2P lending
As long as the economy continues to improve, peer-to-peer lending will continue growing. More and more investors will get involved in this exciting new industry, which will lead to even more competition between lenders and better interest rates for borrowers.
Peer-to-peer lending is a great investment opportunity for people who are interested in earning good returns on their hard-earned money while helping others get loans not accessible otherwise, or pay for important life expenses.
A lot of people have been successful in their P2P lending investments. It’s also clear that a lot of people have lost money because they did not diversify. As with any investment, you should only invest money that you can afford to lose – and once again, remember to diversify your risk by investing on multiple platforms and in many different loans and loan types.