Key takeaways
- Peer-to-peer lending allows individuals to borrow from other individuals rather than traditional banks or financial institutions.
- Borrowers should be cautious of additional fees and potentially higher interest rates when considering a P2P loan.
- Lenders face the risk of losing their money if the borrower defaults on the loan.
- P2P loans can offer lower interest rates for borrowers with good credit and high returns for investors.
Peer-to-peer (P2P) lending emerged in the early 2000s as an alternative option, letting people borrow from other individuals rather than banks or financial institutions. Today, this type of lending has more regulations than in the early days, but there are still questions about the best ways to protect both lenders and borrowers from this type of loan.
Despite debates about regulations, being directly connected over the Internet to a pool of lenders willing to back all or part of a loan can be a helpful alternative to more traditional lenders. Plus, it offers a potential opportunity for individual lenders, also called investors, to make extra money.
However, not all peer-to-peer lending companies are created equal, and the burden of due diligence sits squarely on the shoulders of prospective borrowers and lenders. That’s why it’s important to look out for potential red flags, like additional fees, higher interest rates and lack of FDIC- insurance.
Red flags in peer-to-peer lending for borrowers
Borrowers may find P2P lending a great option if they are short on cash, but there needs to be an increased vetting process before applying for a P2P loan. To reduce the risk of financial harm down the road, borrowers should ensure they are using a reputable lending platform and need a plan in place should they run into any of these red flags.
Borrowers may need to pay additional fees
“If you’re fed up with bank fees, you’ll really hate P2P loans,” says Howard Dvorkin, CPA and Chairman of Debt.com. “On top of the interest rate you’ll pay, there’s the origination fee, which can be as low as 1 percent but as high as 8 percent. That’s much more than a bank or credit union will charge you for a personal loan.”
Traditional personal loans can come with late fees, origination fees, prepayment penalties, non-sufficient fund fees and processing fees. While each fee is often on the lower amount — for example, late fees are often $39 — over time, they add up. Plus, if you have lower credit, the fees will often be even higher on top of higher rates.
That said, P2P loans charge high origination fees and may charge fees similar to personal loans. Before applying for a P2P loan, comb through the terms and conditions to ensure you’re aware of every fee charged and be on the lookout for hidden fees.
Borrowers may get worse rates than with traditional loans
P2P loans can sometimes have lower rates than traditional ones, but borrowers should research. You can often get similar or lower rates with a traditional lending institution.
Dvorkin says it can be tricky to determine if rates will be lower because P2P loans are often marketed to have lower interest rates than traditional lenders. “But it’s actually hard to tell. Is a particular P2P loan really cheaper than your credit union if you have a decent credit score? Especially after you factor in the fees? There’s no easy answer.”
Before applying, crunch the numbers and consider all your lending options to ensure you get the best rate for your credit score. For example, investigate loan rates at local lending institutions, like banks, credit unions and online lenders. Oftentimes online lenders offer the lowest interest rates, with some offering loans to individuals with lower credit scores.
Less support if there is difficulty paying the loan
If a borrower cannot pay off a loan within the agreed-upon terms, lenders have a right to pursue legal action to satisfy the delinquent payments. A traditional bank might offer support such as a payment plan or a longer period to repay the loan before sending a loan to collections. However, peer-to-peer lenders may send a defaulted loan to a collection agency in as little as 30 days.
If your payments are late, a P2P lender may raise interest rates or add fees. If you plan to borrow using a P2P loan, know the terms you are signing up for. A traditional lender could be more lenient with an unpaid loan, but a P2P lender will likely take action against a defaulted borrower more quickly.
Red flags in peer-to-peer lending for lenders
Like most investment opportunities, lenders — or investors — face potential hazards in peer-to-peer lending. If you are interested in becoming an investor in P2P loans, you can have significant returns for your investment, but you should also know the risks you assume when you become a lender.
If the borrower defaults, lenders often lose their money
While some peer-to-peer loans are secured, they are most often unsecured loans. This means the borrower isn’t borrowing against any collateral, and if they can’t pay their loan, the lender loses their money. Whatever money the borrower hasn’t paid back will be lost. While the balance can be sent to collections and pursued in court, property or assets can’t be seized to repay the remaining loan funds.
Loans are not typically FDIC insured
The Federal Deposit Insurance Company (FDIC) is an agency formed by Congress to protect and insure financial transactions in the United States. A loan with a traditional bank is FDIC insured, but many P2P loans are not. Unless funds are deposited in a bank insured by the FDIC, a P2P loan may not have this extra layer of protection.
This means that lenders don’t have the guarantee of seeing their loaned money again like they would with other deposits or investing opportunities. However, there is a potential for positive money gains from investing in a P2P loan, although the risks may be increased compared to other investment opportunities.
Returns may be lower for the lender if the borrower pays early
As the borrower pays the loan, the lender gets their money back. While this may seem like a positive thing, it means that the loan funds are no longer earning interest. If the borrower pays the loan early, you’ll get your original investment back in your account, but the returns will ultimately be lower.
Before investing in a P2P loan, create a plan to combat the potential for low returns by reinvesting the money paid. Should the balances be repaid, this is how to minimize your negative returns.
Why do some people want a peer-to-peer loan?
Both borrowers and lenders may want to try peer-to-peer lending for many reasons. For one, P2P lending often offers lower interest rates for borrowers with good credit scores than traditional lending intuitions.
That said, if borrowers don’t have great credit, P2P lending may allow them to get a loan when a bank might not approve them.
Lenders for P2P loans may be enticed by the high returns they can make compared to other investing options. Typical returns for P2P investors per year average at about 5 percent to 9 percent while some investors see 10 percent or more returns.
The bottom line
P2P loans can be a great option for both borrowers and lenders, but both should carefully weigh the pros and cons when deciding if these types of loans are right for them.
Borrowers should watch out for extra fees or rates comparable to other lenders. P2P investors need to be aware of the financial risks they are taking and understand the returns they may receive compared to other investments.
