Peer-to-peer (P2P) lending has revolutionized the world of small business financing, but is it the right choice for you and your firm? Like other forms of lending, peer-to-peer financing has some exciting benefits and some potential drawbacks. In this article, Daniel Calugar, an experienced investor with a background in business, law, and computer science, takes a look at the pros and cons of P2P lending so that you can make a wise financial decision.
P2P lending, sometimes called social lending or crowdlending, is designed to cut out the middleman – the bank – in a lending situation. P2P lending websites connect would-be borrowers directly with investors that have cash they are willing to lend.
P2P borrowers are typically looking for an alternative to a traditional bank loan, usually in an attempt to secure a better rate than they can otherwise get. The lenders are individual investors looking for a better return on their cash savings than a bank will offer.
The P2P website or platform establishes the interest rates and terms for each transaction. These sites often have a wide range of interest rates available based on the creditworthiness of the applicant. The processing and origination fees charged by the P2P lending platform can range from 2 percent to 6 percent of the loan amount. Both the borrower and the investor may contribute towards the platform’s service fees.
Depending on their credit score, borrowers can expect to pay 6 percent and up for a P2P loan. Investors can invest as little as $25 with an average return of over 5 percent.
From the investor’s or lender’s perspective, P2P lending generally provides a higher return rate than other types of investments. There are, however, additional risks to consider. Many borrowers who apply for P2P loans do so because they have a low credit rating and may not obtain a traditional bank loan. This arrangement can expose the lender to additional risk.
It is also important to note that there is no government protection provided for P2P lenders. They can, of course, take legal action against a borrower that defaults on a loan, but the government offers no loan insurance.
For many investors with cash that they feel can acceptably be exposed to a slightly higher risk, lending money under a P2P arrangement is an excellent way to earn a high return.
From the borrower’s point of view, a P2P loan may represent access to funding that would otherwise be unavailable or more expensive. With a traditional lender, the average personal loan interest rate for a high credit score consumer is 10 percent to 12 percent. With a low credit score, a borrower could pay two or three times that rate.
Not all jurisdictions allow P2P lending, and some require that P2P lending services comply with all applicable investment regulations.
With the first crowdlending platform coming online in 2005, this lending practice is still relatively new. Investors enjoy the flexibility of lending whatever amount they choose and are able to select the loans they would like to participate in based on the risk rating. Borrowers enjoy the lower average interest rates and more accessible funds.