Peer to Peer Lending: How Does It Work?

Peer to Peer lending is a way for regular people who need money to borrow from regular people who have money, usually through an intermediary company like Prosper or Lending Club.

People who want to borrow money but would rather avoid the traditional route of getting a loan from a bank can choose peer to peer lending as an alternative. With peer to peer lending, borrowers visit a p2p website, answer a few questions about their finances and apply for a loan. People with money to invest then lend them the money, in whole or in part, and earn a monthly return.

Peer to peer lending is a growing phenomenon. To date, Prosper has issued over $2 billion in loans, while Lending Club has issued $5 billion.

peer to peer lendingWhat is Peer to Peer Lending?

Peer to peer lending, at its heart, still consists of one regular Joe or Jane lending money to another, with interest. However, the term “Peer to Peer” (or P2P) may lead some people to misunderstand what peer to peer lending really is. While peer to peer started out as a way for regular people to lend money to other regular people, larger businesses quickly capitalized on the idea that those ordinary folks would benefit from an intermediary to smooth out transactions and keep things fair.

Think of it like AirBnB or Uber, but for lending money. With AirBnb, people who own homes and apartments but aren’t going to be using them for a time would like to make money for allowing people to stay in them. Similarly, people in their area would like to pay for a place to stay for the night without resorting to a hotel. All AirBnB does is put those two groups of people together.

peer to peer lending airbnb

P2P lending connects borrowers with individual lenders just like Airbnb connects homeowners with renters.

The Uber online cab service works much the same way. Individuals with cars who’d like to make money for giving people rides are matched with people who need rides and are willing to pay for them. It’s an efficient way of allocating available resources where they’re most needed and everybody wins.

Peer to peer lending follows a similar model. There are people with money who’d like to make more money by lending it to responsible individuals. Likewise, there are people who’d like to borrow money without going to a bank. Peer to peer lending businesses like Prosper and Lending Club just put them together. P2P lending businesses also screen prospective borrowers and rate them based on their credit worthiness. All for a fee, of course.

peer to peer lending prosper

Prosper is one of the biggest peer to peer lending networks.

Peer to Peer Lending for Borrowers

Borrowers can generally borrow up to $35,000 in p2p lending situations, getting larger unsecured loans with lower interest rates than they would through banks. It’s not the wild west though – as with traditional loans, there are credit checks, and the borrower’s credit score determines their interest rate.

peer to peer lending prosper purpose of loan

Prosper borrowers start by choosing a loan amount and selecting the purpose of their peer to peer loan.

Prosper is one of the largest peer to peer lending businesses in the market. Borrowers visit their website and choose a loan amount between $2,000 and $35,000. They then tell Prosper the purpose of their loan and their credit rating to see their interest rate. Interest rates start at 6.68%. The Lending Club is another large p2p lending business that works in exactly the same way.

A borrower seeking $35,000 might get it from ten different lenders. Someone who fails to attract enough lenders to meet the full $35,000 will be denied outright. Borrowers can choose to repay a loan in three years or five years. Just like with traditional loans, missed payments and defaults will result in a black mark on a borrower’s credit report.

Peer to Peer Lending for Investors

p2p lending lending club ratings

Lending Club’s investor rating scale for determining the risk of a p2p loan.

Investors looking for a slice of the p2p pie can enter the market easily. Prosper users create an account, then set loan criteria. Users set the total amount they want to lend and the maximum amount they want to lend per loan. They then select a “Prosper rating,” which is just Prosper’s way of evaluating the level of risk of each loan. Investors can also choose more detailed criteria, like lending only to borrowers who are currently employed or those who already have active loans. Investors can let Prosper select loans for them based on their criteria, or they can browse through the list of currently available loans and pick and choose which ones to bet money on. Prosper advertises “seasoned returns” for investors of 8.89%.

peer to peer lending prosper loan list

Prosper’s p2p loan list.

Lending club similarly lets investors pick loans based on their own system of investment grades from A to G. They claim that 99.9% of their investors see positive returns. They also claim returns of 4.9% to 8.3%.

P2P Lending Investor Pitfalls

The downside of investing in peer to peer lending is the same as with any investment: namely, there’s risk. Despite borrowers being screened by credit rating and investment score, some borrowers still default and it’s possible to lose money.

One big criticism that’s been leveled at peer to peer investing is that things that seem too good to be true often are. For example, it’s been suggested that people who seek loans from peer to peer lending networks often have finances in worse shape than they seem. In other words, many of the people who borrow from p2p networks do so because the banks have turned them down, and that makes them a worse risk than the p2p companies will admit.