While peer-to-peer lending has been around since 2005, it's really caught on in the past few years. In 2015, peer-to-peer lending platforms loaned, giving the traditional lending industry a run for its money.
As high street lenders tightened their rules and became more reluctant to lend following the 2008 financial crisis, peer-to-peer lenders quickly emerged as a more flexible and often cheaper alternative.
But, you may be wondering, how does peer-to-peer lending actually work? And does it really pay to choose a peer-to-peer loan over a traditional one?
What is a peer-to-peer loan?
A peer-to-peer loan is essentially a personal loan.
Just like a personal loan, it allows you to break up the cost of a larger purchase into manageable monthly instalments, instead of having to pay the full price at once. You can also take out a peer-to-peer loan for other reasons, including funding a business venture or, at the other end of the spectrum, bridging the gap until your next paycheck.
Unlike a traditional loan, however, you take out a peer-to-peer loan directly from another individual or group of individuals, without having to go through a bank or financial institution. In other words, you’re cutting out the middleman.
How are peer-to-peer loans different?
Peer-to-peer loans work in much the same way as any other loan: you borrow a sum of money which you then have to repay, with interest, in a set amount of time. However, because you’re borrowing directly from other individuals, peer-to-peer lending is usually more flexible than a traditional loan.
The process also takes place completely online.
Peer-to-peer lending platforms
Unlike banks and financial institutions, peer-to-peer lending platforms act as facilitators, not as lenders.
In a traditional loan scenario, your relationship is with the bank or financial institution itself. By contrast, peer-to-peer lending platforms simply match you to individuals who are prepared to loan you money. They also collect your repayments and take care of the administrative side of things on your lender’s behalf. However, at no point do they loan you any money themselves.
There are various peer-to-peer lending sites around, each with their own pros and cons. Which one you go for really depends on your personal circumstances and what you’re looking for.
As you might expect, different platforms will have different fee structures. More to the point, however, some websites only allow certain types of loans. Keep this in mind when choosing which platform to sign up to.
How does my credit score affect my chances of getting a peer-to-peer loan?
Your credit score affects your ability to take out a peer-to-peer loan in a similar way to how it affects your ability to take out a traditional loan. You’ll probably be able to borrow less - and at a higher interest rate - if you have a poor score. Conversely, a higher score will usually mean you can borrow more money on more favourable terms.
However, because the loan is sourced from individuals, instead of a single commercial institution, you have a greater chance of qualifying for a peer-to-peer loan, even with a poor score.
Let us explain.
Lenders on a peer-to-peer platform are investors. They’re putting up their money in order to obtain a financial return. They’re also taking on the risk that their investment might not produce the desired result. In other words, they’re taking on the risk that you, the borrower, might not pay back the loan.
By law, investors must be asked what their appetite for risk is. This is then used to determine whether a particular type of investment is suitable.
Some lenders will identify as cautious. However, others will be prepared to take on more risk if it means there’s a chance of higher returns. This, in turn, means they may be happy to loan you money even though your credit score suggests you’re a risky investment.
Of course, as with a traditional loan, defaulting will negatively affect your credit score. Your details may also be turned over to a debt collection agency; and you may even be sued for the outstanding amount.
What Are The Advantages Of Peer-To-Peer Loans?
Peer-to-peer loans have a number of advantages over traditional loans. These include:
1. Lower interest rates
Peer-to-peer lending takes place in a largely automated online environment. Compared to a bank or financial institution, there’s much less overhead involved. This usually translates into a cheaper product (read, lower interest rates) for you, the borrower.
2. A higher chance of approval
Most banks and financial institutions have fixed policies and procedures in place. And they tend to turn down anyone who doesn’t fit strictly within these parameters.
On the other hand, peer-to-peer platforms bring together lenders with different risk appetites. So while a particular lender may not want to take you on, another one might be prepared to do so.
What’s more, peer-to-peer loans are usually split between a large number of different lenders, which spreads the risk. This, coupled with a higher interest rate, may make you attractive to a certain category of lender despite your credit score.
Peer-to-peer loans often have a greater degree of flexibility than traditional loans.
Many peer-to-peer platforms let you borrow smaller amounts than traditional lenders. You’ll also have more leeway when choosing your repayment terms. And if you decide to repay your loan early, chances are you won’t incur an early repayment fee.
What Are The Disadvantages Of Peer-To-Peer Loans?
Of course, peer-to-peer loans aren’t without their downsides.
1. They’re unsuitable for certain purposes
Peer-to-peer loans can be very flexible, but there’s usually limit to how much you can borrow and for how long. Mortgages and other long-term lending arrangements are usually out of the question.
2. They’re impersonal
Peer-to-peer lending is a mostly automated process that takes place entirely online. Of course, this is what makes it possible for you to get cheaper rates. However, if you like having the option of face-to-face contact, this may put you off.
That said, reputable peer-to-peer lending platforms should have customer support services you can get in touch with. You can also lodge a complaint with the Financial Ombudsman Service if something goes wrong.
3. Check the terms and conditions carefully
While peer-to-peer loans don’t usually attract early repayment charges, you may still be liable to pay other fees. In particular, look out for processing fees and late repayment fees.
As with any other loan, it’s always a good idea to go through the terms and conditions and make sure you’ve understood them. That way, you’ll avoid nasty surprises.
Got your mind set on taking out a peer-to-peer loan? Before you do so, make sure youris up to snuff.