April 5, 2018. By R. Anthony Norris:
Peer-to-peer lending (“P2P”) is a method for borrowing and lending money without a traditional financial institution. P2P lending platforms match borrowers with investors using modern technology and big data oftentimes reducing costs and streamlining processes online without a traditional brick-and-mortar bank.
P2P lending has been growing in popularity since the financial crises and has become a new source of fixed income for investors. Additionally, the popularity is projected to continue to gain momentum.
Lending Club is currently the largest P2P lending platform, having issued over $20 billion in loans at the time of this writing. Lending club and other platforms lend to a wide range of borrowers from small businesses to individuals. SoFi (short for social finance) is another P2P lending platform that started by only offering loans to Stanford students. Loans were funded by Stanford alumni with the idea that Stanford graduates had a personal connection to the borrowers and trusted they would be paid back. The students taking the loans became known as “high earners, not rich yet” or Henry’s for short.
The reason for P2P lending’s rapid popularity, especially among Henry’s, is the reduced level of complexity and inefficiency normally associated with loan processing procedures at traditional banks. Traditional lending institutions have the resources to collect the necessary information to determine the credit worthiness of a borrower, but unfortunately this process can be expensive and very labor intensive for the borrower. A personal or small business loan from a bank may take several weeks or even several months to get approved and transfer the funds. With peer to peer lending, however, applicants can be approved in a matter of minutes and receive funds in less than a week.
By acting as a mediator, peer-to-peer lending platforms pull information from a centralized data source so that lenders can quickly evaluate the credit worthiness of borrowers. It is important to note, though, that due diligence of investment risk is more difficult on P2P lending sites vs purchasing corporate or government debt bonds the traditional way. The percentage of loans charged off as bad debt through P2P lending is reportedly much higher than consumer loans from banks or even debts held on credit cards. Thus, P2P investors will likely receive higher interest payments from these notes than they would in a traditional savings account due to the greater risk associated with the loan.
Not all P2P lending platforms operate in this manner, however. Although each platform has its own set of algorithms and systems to determine credit worthiness, most platforms will only approve a loan once there is a minimum level of funding, then will issue a securitized note to investors. Other platforms such as Sofi rely on large institutional investors.
Perhaps an even more important point to acknowledge is that P2P platforms are not considered banks and are not held to the same strict regulations that traditional banks must comply with, nor are they FDIC insured. This can result in more favorable rates, though, for both borrowers and investors. Although these lending platforms are not federally insured, some companies do have systems in place to cover investors should defaults occur. In short, as with granting or receiving any loan, it is critical to read the fine print associated with the contract or agreement.
As P2P lending becomes more popular, sites are beginning to expand into new markets of lenders and borrowers. Companies are continually having to deal with increased competition and new regulations. Many argue that these sites act as banks and should be regulated as such. For example, Prosper and Lending Club have had to use a Utah-Based WebBank in order to secure funding for future growth and remain compliant with federal regulation.
If you are considering using a peer-to-peer lending site it is important to review all options. Although these sites work on the same basic principle, they vary in their terms, fee structure, rates, eligibility and so on. As an investor it is especially important to do your research and consult your financial advisors or attorneys with any questions. As mentioned earlier, sites vary in terms of how money flows from investors to borrowers. As such, it is important to consider the liquidity and investment risks, terms, and return of these lending vehicles.