Until recently, the only borrowing options were taking out a loan from the bank or borrowing from a family member. If these options didn’t work out, you were out of luck. But in 2006, that all changed with a new source for loans: peer-to-peer lending.
With peer-to-peer (P2P) lending sites like Prosper.com and LendingClub.com, consumers seeking loans of up to $35,000 can get them simply by finding other individuals to lend to them. This new form of banking has resulted in more than $1 billion in loans made with lenders earning 6-10% back on their returns.
If you haven’t had luck with financing at traditional banks, here’s how peer-to-peer lending may make sense for you.
How peer-to-peer lending works
P2P lending connects investors, which can be individuals and even larger institutions, to individual borrowers.
Borrowers will fill out an application stating what they plan to use the loan for. Both Lending Club and Prosper will review the applicant’s credit and assign a rating to the loan.
Lenders then browse loans and may choose to fund as little as $25 of the requested amount. If the loan is fully funded, the borrower is issued the funds and pays the loan back to the lending site, which then distributes payments back to the investors.
Borrowers can expect to pay interest rates starting around 7%, depending on creditworthiness. Investors can expect about a 6-10% return but run the risk the loan isn’t repaid.
Why P2P lending?
P2P lending serves as an alternative to the traditional borrowing process, and offers some advantages in flexibility to borrowers.
One advantage: To borrow money, you don’t need to meet a bank’s standards. Borrowers simply have to convince others to lend money to them. This is typically done by providing lenders a convincing reason to invest as well as having a decent credit score.
P2P also provides opportunities to borrow money where traditional banks might not want to lend. Borrowers use P2P lending for a variety of purposes, including:
- Refinancing credit cards and auto loans. With the lowest P2P borrowing rates just under 7%, refinancing can bring big savings for credit card debt, where interest rates can be more than 20%.
- Personal loans. Banks may not be eager to give you a personal loan. Since P2P lending has less restrictions on what you can loan money for, you simply need to convince investors to fund your request.
- Funding a small business. Just like with personal loans, P2P lending can be a better fit for funding a business venture than traditional banks.
For lenders, the advantage is lucrative returns. Lending money on P2P sites often dwarfs returns of both savings accounts as well as some traditional investments. These returns have become so attractive that some larger institutional investors have started lending.
Downsides of P2P lending
While peer-to-peer lending may sound like the way to go, it isn’t going to be a perfect solution for everyone.
Receiving a loan is far from guaranteed through P2P sites. Only about 60,000 loans have been funded on Lending Club compared to the 550,000 that were not funded. Since the debt is unsecured, lenders may still be reluctant to lend money to borrowers that don’t have very good credit.
Both Prosper and Lending Club both have caps on the loan amount, with limits set at $25,000 and $35,000, respectively. Because of this, there’s limited utility in what you can actually use the money for, meaning you probably won’t be financing a home purchase using P2P lending.
Not all states allow peer-to-peer lending, either. For Prosper, Iowa, Maine, and North Dakota do not allow borrowing. For Lending Club, residents in those states plus an additional five (Idaho, Indiana, Mississippi, Nebraska, and Tennessee) are ineligible for borrowing.
P2P lending alternatives
Peer-to-peer borrowing might not make sense in all cases.
If you have excellent credit, sticking with traditional banks may still get you the best rates. Be sure to compare before going straight for P2P options.
For reducing credit card interest rates, 0% APR cards might still be a good deal. After all, it’s hard to beat zero interest if it’s available to you.
If you’re in serious debt, different debt management programs could be the best option, too, which not only reduces interest rates but provides counseling to help prevent future debt.