As traditional banks have raised interest rates and tightened their credit standards, a large number of people are moving towards the new concept of peer to peer loans. They come in as a valuable alternative to individuals who are not capable of or willing to access institutional finance.

The earlier alternative was to borrow from family and friends. However, that had social stigma involved since it meant disclosing your financial position to other people who may know you.

Peer to peer loans has come as a solution for people who want to borrow from other individuals. For the borrower, there are obvious benefits involved. For the lender too, the rates of return can be pretty high, and it provides diversification too.

In this article, we will have a closer look at this concept of peer to peer loans. We will also analyze the pros and cons.

What is Peer to Peer Lending ?

Peer to peer lending is an algorithm that matches the needs of the borrower with that of the lender. This whole process takes place anonymously with the peer to peer platform playing mediator between the different parties. A typical peer to peer loan functions in the following manner.

1. In the first step, unsecured personal loans are transferred to the account of the borrower. Here, the peer to peer lenders deducts an origination fee. This is one of their sources of revenue. On an average peer to peer lenders charge 3% to 5% of the loan amount as an origination fee.

2. These loans have a reasonable interest rate. They are amortized over a period of one to five years. However, there is usually no penalty for prepayment.

3. Lastly, the peer to peer loan platform automatically deducts payments from the verified bank accounts of the borrowers. Here too, the platform charges a small fee for every payment made. This is another source of revenue for the peer to peer lenders.

The peer to peer lenders has a purely online presence. They do not have any physical infrastructure like branches, employees, etc. This is because they want to keep the costs really low. This is what allows them to charge reasonable interest from the borrowers and yet provide sizeable returns to the investors at the same time.

What Purposes Do Peer to Peer Lenders Provide Loans For ?

Peer to peer lenders offer loans for both personal as well as business purposes. Typically loans are taken for debt consolidation, medical expenses, home improvements, etc. However, fairly large loans are also given on these platforms for starting a small business. Sometimes people even use peer to peer loans to come up with financing for their car or money for a down payment on their mortgage.

Benefits of Peer to Peer Loans

• Easily Available: The biggest benefit of peer to peer loans is the fact that it is easily available. These loans are typically taken via an internet application. Within a few hours, the disbursed money is available in the borrower’s account. Also, the loan is provided anonymously meaning that the borrowers do not know who the lender is and vice versa.

• Lower Interest Rates: Since individuals provide peer to peer loans, the costs are relatively low. These loans are generally availed by people who have a lot of debt and are unable to obtain financing from the regular channels. The other alternatives they have to peer to peer loans are credit card financing or payday loans. Peer to peer lending is much more user-friendly and provides the borrower with an opportunity to get their finances in order.

• Pooling of Funds: The loans given to the borrower are seldom given by one lender. Instead, funds from several lenders are pooled and loans are provided. The risks and rewards are then apportioned on a prorated basis. Hence, the risk to individual investors is comparatively low. Some investors have compared investing in peer to peer loans with investing in equity because they believe that both have a similar risk profile.

Disadvantages of Peer to Peer Loans

• Losing Money: There is a significant chance of losing investments in peer to peer loans. This is if the investor decides to invest in the high-risk high-return bucket. These loans are made to people with low credit scores. Defaulting on peer to peer loans is likely to make their credit scores even worse and significantly reduce their ability to borrow money.

• No Regulation: Peer to peer lending is not subject to any form of regulation. This can be dangerous in the context of borrowing money. Several usurious malpractices have been reported in the past which has led to the creation of these regulations. A borrower needs to thoroughly scrutinize the paperwork of peer to peer loans to ensure that they do not agree to usurious terms. These contracts are not standardized, and terms and conditions may vary widely across lenders.

• Not Insured: Since there is no regulation of peer to peer loans, there is also no insurance provided by the Federal Deposit Insurance Committee (FDIC). This increases the risk profile significantly. Even though peer to peer loans pay twice the rate of a savings bank account, they are still risky without the $100000 insurance from the federal government.

To sum it up, peer to peer loans are an attractive alternative for borrowers who want privacy or who have been turned down for loans by traditional banks. However, these loans have their fair share of issues which both the borrower and the lender must be vigilant about.