Peer-to-Peer Lending

peer peerPeer peer lending (P2P) is a method of debt financing that enables individuals to borrow and lend money – without the use of an official financial institution as an intermediary. P2P lending removes the middleman from the process, but it also involves more time, effort and risk than the general brick-and-mortar lending scenarios.

The advantage to the lenders is that the loans generate income in the form of interest, which can often exceed the amount interest that can be earned by traditional means (such as from saving accounts and CDs). Plus P2P loans give borrowers access to financing that they may not have otherwise gotten approval for by standard financial intermediaries.

The method is not without its disadvantages as the lender has very little assurance that the borrower, who traditional financial intermediaries may have rejected due to a high likelihood of defaults, will repay their loan. Furthermore, depending on the lending system employed, in order to compensate lenders for the risk that they are taking, the amount of interest charged for peer to peer loans may be higher than traditional prime loans.

P2P is the practice of lending money to individuals or businesses through online services that match lenders with borrowers. Since peer-to-peer lending companies offering these services generally operate online, they can run with lower overhead and provide the service more cheaply than traditional financial institutions.

As a result, lenders can earn higher returns compared to savings and investment products offered by banks, while borrowers can borrow money at lower interest rates, even after the P2P lending company has taken a fee for providing the match-making platform and credit checking the borrower. There is the risk of the borrower defaulting on the loans taken out from peer-lending websites.

Also known as crowd lending, many peer-to-peer loans are unsecured personal loans, though some of the largest amounts are lent to businesses. Secured loans are sometimes offered by using luxury assets such as jewelry, watches, vintage cars, fine art, buildings, aircraft and other business assets as collateral. They are made to an individual, company or charity. Other forms of peer-to-peer lending include student loans, commercial and real estate loans, payday loans, as well as secured business loans, leasing, and factoring.

The interest rates can be set by lenders who compete for the lowest rate on the reverse auction model or fixed by the intermediary company on the basis of an analysis of the borrower’s credit.The lender’s investment in the loan is not normally protected by any government guarantee. On some services, lenders mitigate the risk of bad debt by choosing which borrowers to lend to, and mitigate total risk by diversifying their investments among different borrowers. Other models involve the P2P lending company maintaining a separate, ring fenced fund, such as RateSetter’s Provision Fund, which pays lenders back in the event the borrower defaults, but the value of such provision funds for lenders is subject to debate.

The lending intermediaries are for-profit businesses; they generate revenue by collecting a one-time fee on funded loans from borrowers and by assessing a loan servicing fee to investors (tax-disadvantaged in the UK vs charging borrowers) or borrowers (either a fixed amount annually or a percentage of the loan amount). Compared to stock markets, peer peer lending tends to have both less volatility and less liquidity.

Peer to peer lending does not fit cleanly into any of the three traditional types of financial institutions—deposit takers, investors, insurers, and is sometimes categorized as an alternative financial service.

Typical characteristics of peer to peer lending are:

– it is sometimes conducted for profit;
– no necessary common bond or prior relationship between lenders and borrowers;
– intermediation by a peer peer lending company;
– transactions take place online;
– lenders may often choose which borrowers to invest in, if the P2P platform offers that facility;
– the loans can be unsecured or secured and are not normally protected by government insurance but there can be protection funds like those offered by Zopa and RateSetter in the UK;
– loans are securities that can be transferred to others, either for debt collection or profit, though not all P2P platforms provide transfer facilities or free pricing choices and costs can be very high, tens of percent of the amount sold, or nil.

Early peer peer lending was also characterized by disintermediation and reliance on social networks but these features have started to disappear. While it is still true that the emergence of internet and e-commerce makes it possible to do away with traditional financial intermediaries and that people may be less likely to default to the members of their own social communities, the emergence of new intermediaries has proven to be time and cost saving. Extending crowdsourcing to unfamiliar lenders and borrowers opens up new opportunities.

Most peer peer intermediaries provide the following services:

– online investment platform to enable borrowers to attract lenders and investors to identify and purchase loans that meet their investment criteria;
– development of credit models for loan approvals and pricing;
– verifying borrower identity, bank account, employment and income;
– performing borrower credit checks and filtering out the unqualified borrowers;
– processing payments from borrowers and forwarding those payments to the lenders who invested in the loan;
– servicing loans, providing customer service to borrowers and attempting to collect payments from borrowers who are delinquent or in default;
– legal compliance and reporting;
– finding new lenders and borrowers (marketing).

 


 

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