Peer-to-peer lending is a modern name for a practice as old as money itself — individuals loaning money among themselves. What’s modern is the scale afforded by technology. Ten years ago, an individual needing a loan to start a business, consolidate debt, or cover unexpected home improvements would have been limited to borrowing from his or her immediate friends, family, and acquaintances outside of a traditional bank loan. Today, online peer-to-peer (P2P) lending platforms connect individuals who need to borrow money with investors willing to lend. Technology now allows perfect strangers to borrow from and lend to each other.
For many people, borrowing from peers can be a great alternative to borrowing from a bank, but it’s not for everyone. We’ll take a look at how peer-to-peer lending works and what you need to know before you apply.
How P2P loans work
The Small Business Administration (SBA) defines P2P lending as, “Individual investors providing small sums to lend personal loans to individuals via internet platforms.” Some of the most popular platforms include LendingClub, Prosper, Upstart and Funding Circle, although there are several others.
Potential borrowers can apply for credit on the platform, and borrower qualifications vary by lender. For example, the interest rate a LendingClub borrower receives depends on an internal score developed by the company, which is one of the largest P2P lenders. “They will give you a grade between A (the best grade, qualifying for the highest amount at the lowest rates) and G (the lowest grade with the highest interest rate),” a LendingClub spokesperson told MagnifyMoney.
LendingClub currently caps its personal loans at $40,000. Prosper caps its loans at $35,000. Typical loan terms range between three and five years.
Who invests in P2P loans
P2P loans may be funded by an individual investor or a group of investors. According to MarketWatch, P2P loans can be a good way to diversify the portfolio of income investors who take time to understand the risks and rewards. Income investing generates a cash income in the form of dividends and interest. In other words, investors don’t buy a stock, bond, or other investment and wait for it to appreciate in value so they can sell it and earn a profit. Simply holding on to the investment generates income.
P2P loans are an income investment because once an investor opens an account and chooses to participate in a loan, principal and interest payments (less fees charged by the platform) are deposited into the investor’s account on a monthly basis.
The investors may be individuals or institutions, such as banks, pension plans, foundations, finance companies, asset managers, insurance companies, broker-dealers, and hedge funds. Individual investors can open an account with Lending Club with an initial investment of $1,000, but other platforms are available only to institutions and accredited investors (those who can demonstrate high-earned income and net worth).
Connor Murphy, a public relations and communications specialist with Funding Circle, says their platform in the U.S. is only open to accredited investors and institutional investors. “We actually use the term ‘marketplace lending’ rather than peer-to-peer lending,” Murphy said, “because investors on our platform globally include large financial institutions and even governments.”
Whether the investor is an individual with $1,000 or an institution looking to invest $250,000, they select loans to invest in and earn monthly returns on. According to Sarah Cain, head of communications at Prosper, borrowers do not know their lenders. “They simply know if their loan has been funded or not,” Cain said.
Why P2P loans?
P2P lending platforms started gaining traction more than a decade ago as a way to bypass banks and use technology to connect investors with money to the borrowers that need it. P2P lenders have claimed their online platforms help them reduce costs, and that, in conjunction with analytics and proprietary algorithms, allow them to offer borrowers lower interest rates or provide loans to individuals who have been refused loans by traditional banks.
LendingClub currently advertises APRs for personal loans from 5.99 percent to 35.89 percent. The company surveyed borrowers during the first seven months of 2017 and found that borrowers who received a loan to consolidate existing debt or pay off credit card balances reported that they saved an average of $287 per month. However, that statistic compares high-interest credit card rates with personal loan rates – not P2P personal loan rates to bank personal loan rates.
As of August 2017, the average APR on credit cards carrying a balance was 14.89 percent, but banks may offer much lower rates for personal loans. Of course, whether you choose a P2P loan or a bank loan, having a high credit score can help you get the lowest rate offers, while a lower credit score will likely stick you with higher interest rates, if you are approved for a loan at all.
Some borrowers just prefer the idea of avoiding large, traditional banks. But as with any borrowing decision, you should compare apples to apples when seeking financing for any purpose and shop around for the best rate.
Applying for a peer-to-peer loan
To apply for a loan, a potential borrower visits a P2P lending website and fills out an application.
The platform leverages online data and technology to assess risk, determine a credit rating and assign an appropriate interest rate. Applicants may receive offers within a few minutes and can evaluate options without impacting their credit score. Once you select a loan offer, you’re required to complete an online application that gathers information about your income and employment as well as identifying information, such as address and Social Security Number.
You may also be required to provide additional documentation to verify your identity, income, and employment. That may include:
- Tax forms such as W-2s and 1099s
- Tax returns
- IRS Form 4506-T, which is used to request a copy of your tax forms or returns directly from the IRS
- Recent bank statements or pay stubs
- Proof of income from alimony or child support, pension or annuity income, disability insurance or workers compensation benefits, if applicable
- Copies of government-issued photo ID
- Utility bills
Once you’ve completed the application and submitted the necessary documents, your application is reviewed and the platform matches you with investors to fund the loan. Once the loan is approved, the funds are deposited into your bank account. The process can take anywhere from seven to 45 days.
Each P2P site has its own rules and approval criteria, including minimum credit score, so an application declined by one platform doesn’t necessarily mean that you won’t be approved by the others.
The Financial Industry Regulatory Agency (FINRA) reported that P2P lenders tend to be more forgiving than banks when it comes to short credit histories, but if you’re trying to get a P2P loan with less than stellar credit, don’t expect the lowest rates.
Lending Club states that applicants who qualify for the lowest rates have:
- An excellent credit score
- A low percentage of total outstanding debt compared with income
- A long history of credit with significant successful credit lines
Upstart looks for borrowers with:
- A minimum FICO score of 620 (although they do accept borrowers with insufficient credit history to produce a FICO score)
- No bankruptcies
- No accounts currently in collections or delinquent
- Fewer than six inquiries on their credit report in the last six months (other than inquiries for student loans, vehicle loans, or mortgages
Prosper’s minimum criteria include:
- A minimum FICO score of 640
- Debt-to-income ratio below 50%
- No bankruptcies within the last 12 months
- Fewer than seven credit inquiries within the last six months
While the approval process isn’t without its hurdles, peer-to-peer loans give borrowers another — sometimes less expensive — option for borrowing beyond credit cards and bank loans. Because P2P lenders facilitate borrowing without a bank intermediary, there is less overhead and none of the capital reserve requirements that drive up costs for traditional banks. As a result, the cost of originating and funding loans is lower, providing more competitive rates to borrowers and a faster approval process.
Plus, some borrowers just like the idea of borrowing outside of the traditional banking industry. Cain says although the process is online, P2P lending is not simply a different way of dealing with a faceless lender. “We do have a robust customer service team that is available to help,” Cain said.
What if your loan isn’t funded?
If your loan application is denied, you will receive an adverse action notice that provides the specific reason for the denial.
Cain says it’s hard to say exactly why a loan application would be denied, as every person’s credit profile is unique. However, some common reasons credit applications may be denied even though the borrower has a good credit score include:
- Problems verifying employment. A stable job and stable income indicate that you’ll be able to pay your lender back. If the lender has trouble verifying your employment history, they may decline your application.
- Not enough income. If you don’t have enough income in relation to your existing debt obligations to pay back the loan, most lenders will deny credit.
- Bankruptcy. Lenders are often wary of approving a loan after you’ve declared bankruptcy. A bankruptcy may remain on your credit report for up to seven or 10 years, depending on the type filed.
- Credit card utilization. If you are using a large percentage of your available credit, you may be seen as a potential risk to lenders.
If your loan application is denied, check your credit report to make sure that there are no inaccuracies that are dragging down your credit score. You can check your credit report with each of the three credit reporting agencies for free once a year at annualcreditreport.com.
Also, review your loan application to ensure you filled it out completely and accurately. If you find any errors in your credit report or application, correct them and apply again. Otherwise, take a look at the adverse action notice and see what you can do to improve your situation.
While there are no quick fixes for a bad credit score, small steps can improve your score over time.
- Reduce the amount you owe. Stop using credit cards and make a plan to pay down existing balances.
- Pay your bills on time. Payment history accounts for as much as 35 percent of your FICO score, so set up payment reminders to avoid missed or delinquent payments.
- Avoid closing unused cards. Part of your credit score depends on the average length of time you’ve been using credit, so closing old accounts can actually hurt your score.
- Don’t open new accounts too rapidly. A large number of new accounts in a short time frame can make you look risky to lenders, so apply for and open new accounts only as needed.
Each platform has their own lending criteria, loan limits, fees, interest rates, and areas of operation. Take a look at the FAQs and other information on the provider’s website to get an overview of the types of loans they offer, and the rates and fees they charge.
Here are a few to get started:
Who it’s best for:
3 and 5 years
Borrowers who may not have an
3 and 5 years
Borrowers interested in a personal
3 and 5 years
Borrowers interested in a personal
6 months to 5 years
Borrowers looking for funding to start
Keep in mind that interest rates and other terms can change, so you should compare rates and other terms from a variety of lenders every time you need to borrow.
The P2P lending market is only a little over a decade old, thus P2P platforms have not had the long history of government oversight to which banks and credit unions have been subjected.
And there is reason to be cautious about getting involved in P2P lending. In 2016, the Department of the Treasury released a report, Opportunities and Challenges in Online Marketplace Lending, looking at the opportunities and risks of P2P lending. Their concerns included:
- The use of data-driven algorithms for making credit decisions has the potential to violate fair lending laws and doesn’t allow applicants to check and correct the data being used.
- Interest rates may be high. The report acknowledged that the majority of loans are made to borrowers with good credit scores, but some platforms offer loans to borrowers with poor credit (FICO scores as low as 580) at interest rates as high as 36 percent.
- Borrowers using P2P lending to refinance federal student loans lose the protections available to federal student loan borrowers, including income-driven repayment plans, loan forgiveness, and deferral or forbearance while the borrower returns to school or faces economic hardship or disability.
- Many borrowers use P2P loans to fund small business development, but it may be difficult to enforce consumer protection laws and regulations, contract law, or fair lending laws with P2P platforms since these platforms are not subject to the same oversight as traditional banks.
- While many marketplace lenders clearly disclose loan rates and terms, not all platforms are as transparent. The report acknowledged a need for standardized disclosures.
- Most P2P platforms service loans only until a loan becomes delinquent, at which point collection is outsourced to a collection agency. Not all platforms have plans in place to work with borrowers who are experiencing financial distress or plans to continue servicing loans if the company goes out of business.
However, they are required to follow the same state and federal laws as other lenders. If you encounter any problems with a P2P lender, you should submit a complaint to the Consumer Financial Protection Bureau.
The CFPB began accepting complains about P2P lenders in March of 2016. We reviewed the complaints database in December of 2017 and counted more than 300 complaints about some of the largest P2P lenders. Consumers who submit complaints assign categories themselves and can opt not to have their complaint narrative published, so it’s difficult to parse the top complaints, but they include:
- Having difficulty getting the loan
- Problems making payments
- Problems with the payoff process
- Being charged interest or fees that aren’t expected
- Inaccurate information reported to the credit bureau
These problems aren’t unique to P2P lenders, given that borrowers from traditional banks can face similar frustrations. Still, it’s important to know what other borrowers have experienced if you’re thinking of pursuing a P2P loan.
Lending Club and Prosper are the most popular platforms, but experts expect the industry to grow, so it’s worth expanding any comparison shopping beyond the biggest players. Just do your research before providing your personal information.
- Search for the lender online. Is the platform mentioned in roundups of the best P2P platforms from reputable financial websites? Do your search results include consumer complaints?
- Check the platform’s rating with the Better Business Bureau.
- Make sure the platform takes steps to protect your personal data. They should have security and privacy certification from a company like TRUSTe or Symantec.
Alternatives to a P2P loan
It makes sense for anyone interested in a P2P loan to also compare alternatives before committing to a loan:
- Community banks
- Credit unions
- Friends and family
Peer-to-peer lending can be a less expensive alternative to high-interest credit cards and easier to get than a bank loan. But, like all borrowing decisions, it needs to be carefully considered for your individual financial circumstances. The bottom line is that P2P is another option, and more options and increased competition are always good for borrowers.