Peer-to-peer (P2P) lending came about in the early 2000s as an alternative lending option, letting people borrow from other individuals rather than banks or financial institutions. Today, this type of lending has more regulations than it did in the early days, but there are still questions about the best ways to protect both lenders and borrowers for this type of loan.
Despite debates about regulations, being directly connected over the Internet to a pool of lenders willing to back all or part of a loan can be a helpful alternative to more traditional lenders. Plus, it offers an opportunity for individual lenders, also called investors, to make some possible extra money.
However, not all peer-to-peer lending companies are created equal, and the burden of due diligence sits squarely on the shoulders of prospective borrowers and lenders. That’s why it’s important to look out for red flags before getting involved with a P2P loan.
Red flags in peer-to-peer lending for borrowers
Borrowers may find P2P lending to be a great option if they are short on cash, but there are some red flags to look for before applying for a P2P loan. Borrowers should make sure they are using a reputable lending platform and plan accordingly if they encounter any of these potentially troubling signs.
Borrowers may need to pay additional fees
“If you’re fed up with bank fees, you’ll really hate P2P loans,” says Howard Dvorkin, CPA and Chairman of Debt.com. “On top of the interest rate you’ll pay, there’s the origination fee, which can be as low as 1 percent but as high as 8 percent. That’s much more than a bank or credit union will charge you for a personal loan.”
Borrowers may get worse rates than with traditional loans
P2P loans can sometimes have lower rates than traditional loans, but borrowers should do their research. You can often get similar or lower rates with a traditional lending institution.
Dvorkin says that it can be tricky to figure out if rates will be lower because P2P loans are often marketed to have lower interest rates than traditional lenders. “But it’s actually hard to tell. Is a particular P2P loan really cheaper than your credit union if you have a decent credit score? Especially after you factor in the fees? There’s no easy answer.”
Make sure you run all of the numbers before deciding which option is cheaper for you.
Less support if there is difficulty paying the loan
If a borrower is unable to pay off a loan within the originally agreed terms, lenders have a right to fight for their money back. A traditional bank might offer support such as a payment plan or a longer period to pay back the loan before sending a loan to collections or pursuing legal action. However, peer-to-peer lenders may send a defaulted loan to a collection agency in as little as 30 days.
If your payments are late, a P2P lender may also start to raise interest rates or add fees. If you plan to borrow using a P2P loan, make sure you know the terms you are signing up for. A traditional lender could be more lenient with an unpaid loan, but a P2P lender will likely take action against a defaulted borrower more quickly.
Red flags in peer-to-peer lending for lenders
Lenders also face some potential hazards in peer-to-peer lending. If you are interested in becoming an investor in P2P loans, you can have significant returns for your investment, but you should also know the risks you assume when you become a lender.
If the borrower defaults, lenders often lose their money
While some peer-to-peer loans are secured, they are most often unsecured loans. This means the borrower isn’t borrowing against any collateral, and if they can’t pay their loan the lender loses their money. Whatever money the borrower hasn’t paid back will be lost.
Loans are not typically FDIC insured
The Federal Deposit Insurance Company (FDIC) is an agency formed by Congress to protect and insure financial transactions in the United States. A traditional loan with a traditional bank is FDIC insured, but many P2P loans are not. Unless funds are deposited in a bank insured by the FDIC, a P2P loan may not have this extra layer of protection.
Returns may be lower for the lender if the borrower pays early
As the borrower pays back the loan, the lender gets their money back. This money stops earning interest once it is paid back. If the borrower pays back the loan early, the lender earns interest for a shorter period of time. This means lower returns for the lender.
Lenders should be cautious of this. Choosing to continually reinvest the money that is paid back will help them to get the highest returns in P2P lending.
Why do some people want a peer-to-peer loan?
There are many reasons both borrowers and lenders may want to try peer-to-peer lending. P2P loans may be just the right alternative for certain borrowers.
For borrowers with good credit scores, P2P lending often offers lower interest rates than traditional banks or lending institutions. If borrowers don’t have great credit, P2P lending may allow them to get a loan when a bank might not approve them for one.
Lenders for P2P loans may be enticed by the high returns they can make compared to other investing options. Typical returns for P2P investors per year average at about 5 percent to 9 percent while some investors see returns of 10 percent or more.
Bottom line
P2P loans can be a great option for both borrowers and lenders, but both should weigh the pros and cons carefully when deciding if these types of loans are right for them.
Borrowers should watch out for extra fees or rates that are comparable to other lenders. P2P investors need to be aware of the financial risks they are taking and understand the returns they may receive compared to other investments.
