There are plenty of reasons to look at various options for borrowing money when you need it. A mortgage to buy a home, auto loan to purchase a car, or student loans to attend college.
If you need money for other reasons, you might consider a personal loan or a cash advance from your credit card.
Taking out a peer-to-peer loan is yet another way to borrow money. The following information explains P2P loans and how they work. We'll also cover the pros of this method of borrowing money and the potential downsides.
What is a Peer-to-Peer Loan?
Peer-to-peer lending is a type of social lending.
Rather than applying for a loan from a bank, credit union, or other financial institution, peer-to-peer lending allows you to obtain a loan with funds from individual investors via an online platform.
This non-traditional loan option has become quite popular with borrowers. Research from the last five years shows that early start-ups have turned P2P lending into a $2 billion industry.
Borrowers can apply for loans of up to $40,000 on many P2P lending sites.
How Do P2P Loans Work?
A quick internet search yields dozens of peer-to-peer lending websites. Some of the most popular sites include Prosper, Lending Club, Peerform, and Upstart.
Note: If you’re considering taking a P2P loan, make sure you research various platforms to understand all the terms and conditions of the transaction you plan to make.
Most P2P lending sites allow you to check your interest rate without completing a full application.
You’ll answer questions including how much money you need, the purpose of the loan, and your primary source of income.
Lending sites then do a “soft pull” (which doesn’t affect your credit score) to determine an interest rate they'll likely offer when you apply for a loan.
After choosing the peer-to-peer lender you want to work with, you’ll register for an account and complete an online application.
The application is much like any other loan application. You'll provide personal data, credit history information, your borrowing goal, and the purpose of seeking a loan.
After a credit check and approval, private investors can start funding your loan. While many loans fund quickly, that isn’t always the case. Some loans take weeks to fund and others may never be funded by investors.
When funded, most loans have terms of 3 to 5 years – often with no prepayment penalty. Funds are electronically transferred into a borrower’s account and loan payments are made with automated (ACH) bank drafts.
The peer-to-peer lender is responsible to record payments, pay investors who fund the loan, and collect fees. They also report payments to the credit bureaus until the loan has been repaid.
Pros of Peer-to-Peer Borrowing
The option of getting a P2P loan online through social or marketplace lending has many advantages for borrowers.
Fast & Convenient. Applying for a peer-to-peer loan online is a fast and convenient process versus applying for loans with local lenders.
Competitive Rates. Interest rates for P2P loans are also competitive. According to Experian, the average interest rate on a personal loan is 9.41%. Rates generally range from 6% – 36% depending on your credit score.
This directly aligns with loan rates on the popular P2P lending site Prosper. Borrowers with excellent credit (A rating) receive offers as low as 5.99% APR. Those in the HR (high risk) group may pay an APR up to 35.97%.
Higher Approval Rates. Borrowers who've been denied loans by traditional lenders may still be approved for P2P loans.
While you’ll likely pay a very high-interest rate for the loan, it may be a better choice than adding to your credit card debt. Or an even worse option – a payday loan.
Lower Origination Fees. Every loan has fees. If you don’t make a payment on time or your payment doesn’t go through because of insufficient funds, you’ll pay a fee. But one place you might save some money on a peer-to-peer loan is on the origination fee – the fee to process your loan.
Origination fees are usually a percentage of the loan you’re taking out. Major lenders charge between 1%-8% of the loan to cover these fees on personal loans.
Rates vary based on factors including the borrower’s credit history, the amount and term of the loan, the reason for the loan, and other information in the application.
The online P2P platform Lending Club charges origination fees of 1%-6%. Competitor Peerform’s fees are 1-5% of the loan amount. Prosper’s loan closing fees vary from 0.5%-4.95%, with those having excellent credit saving the most in costs.
Those with poor credit (considered high risk of defaulting) can also save hundreds of dollars on fees with some P2P loans.
If interest rates and terms are comparable with traditional lenders charging 8% origination fees, borrowers save 2-3% of that fee by taking a loan from a peer-to-peer lender.
Potential Negatives of P2P Borrowing
Peer-to-peer loans have some downsides for borrowers to consider as well.
Approval Doesn’t Ensure Funding. Even if you receive approval for a P2P loan, it doesn’t mean you'll actually receive funds from investors.
If your loan request receives insufficient investor commitment, you won’t get the cash you want.
When working with a traditional lender and obtaining approval for a loan, you won’t have to worry about if or when it is funded.
Default Can Be Costly. Most peer-to-peer loans are unsecured personal loans which are a higher risk to investors.
Should you fail to make payments on this type of loan, there's no collateral for lenders to sell to recoup their money. Your debt will likely be sold to a collection agency who will contact you (repeatedly) for payment.
Keep in mind if your debt is sent to collections it has a significant negative impact on your credit score and history. It takes seven years for debt that has gone to collections to be removed from your credit report.
A bad credit score affects your ability to receive approval for more credit and results in higher interest rates. You may even get turned down for an apartment lease or a new job if they do a credit check.
Final Thoughts on Peer-to-Peer Loans
When money is tight, you may be looking at every option available to borrow money. But it’s important to look at the expense and determine whether it’s a need or a want.
When considering borrowing to pay for a “want” stop and reconsider. It's often a smarter move to start a sinking fund and put off the expense or purchase until you save up enough to pay for it without having to incur interest charges.
If you don’t have enough money to pay for your basic needs, carefully consider all your options. A peer-to-peer loan may be the right decision for one person while taking a loan from a relative is better for someone else.
Others may choose to take out a personal loan at a bank, apply for a home equity loan or cash-out refinance, use cash from a 0% balance transfer credit card offer, or even take a cash advance from a credit card.
( Read more about why taking a payday loan should be an absolute last resort here.)
Calculate how much money you really need. Then, compare interest rates, terms, and fees for various borrowing options.
You’ll want to pay as little in interest as possible. But you also want to ensure you obtain a monthly payment you can afford.
Then you'll be better able to fulfill the terms of your loan, avoid late fees, and having your debt sent to collections.