What Is Peer-to-Peer Lending?

A couple trying to learn about peer-to-peer lending and what it can do for their portfolio.

Peer-to-peer (P2P) lending is a lending model where individuals or small businesses borrow money directly from individual investors through online platforms. Borrowers apply for loans, undergo credit assessments, and have their loan requests listed on P2P lending platforms. Investors then have the opportunity to fund these loans partially or in full. If you want to learn more about peer-to-peer lending, consulting a financial advisor could offer personalized advice to help you make smart borrowing decisions.

How Peer-to-Peer Lending Works

At its heart, peer-to-peer lending carves out a system where the necessity for a middleman, like a traditional banking institution, vanishes. Individuals lend and borrow directly, bringing the power of the banking model to every home through online platforms. Imagine John, a small business entrepreneur in need of capital for expansion. He turns to a peer-to-peer platform and finds Mary, an investor looking to support local businesses. The platform connects John and Mary, facilitating a loan that meets both their needs. Simplicity and community support are the hallmarks of this model.

Once loans are funded, borrowers make regular repayments, including principal and interest and these payments are distributed to the investors. P2P lending offers borrowers an alternative source of credit while giving investors the potential for competitive returns, though it comes with the risk of borrower defaults. Additionally, some platforms offer a secondary market for investors to sell their loans.

P2P lending has gained popularity as a way to connect borrowers and lenders directly, bypassing traditional financial institutions. However, both borrowers and investors should carefully evaluate the terms, creditworthiness, risk associated with loans, diversify investments and be prepared for potential defaults to make the most of this lending model.

Differences From Regular Lending

Peer-to-peer lending is characterized by digital technology, less stringent borrowing criteria and a potential for higher returns.

It differs from traditional lending, which offers loans from banks or credit unions, in several key ways:

Source of Funding:

P2P lending: Individuals or investors fund loans for other individuals or small businesses through online platforms. It is a decentralized form of lending.
Traditional lending: This involves banks, credit unions or financial institutions as the primary source of funds for loans.

Lender-Borrower Relationship:

P2P lending: Typically involves a direct relationship between individual lenders and borrowers, which is facilitated by an online platform. Borrowers are often matched with multiple lenders.
Traditional lending: Borrowers have a relationship with a bank or financial institution, and deal with loan officers or bank representatives.

Interest Rates:

P2P lending: Interest rates on P2P loans can vary widely based on the borrower’s financial status and other factors. Investors set the interest rates they are willing to lend at, which can result in competitive rates.
Traditional lending: Traditional lenders typically offer fixed or variable interest rates that correspond with Federal Reserve rates. They also consider the interest rates charged by competitors, market conditions and the borrower’s credit score. These interest rates can be less negotiable.

Loan Terms:

P2P lending: These loans may offer more flexible loan terms, with shorter or longer durations, depending on the platform and the agreement between the borrower and lenders.
Traditional lending: Traditional loans generally have standardized loan terms and structures set by the lending institution, with less flexibility for borrowers.

It’s important to note that both P2P lending and traditional lending have their advantages and disadvantages, and the choice between them depends on individual preferences, risk tolerance and specific financial needs. Borrowers and investors should carefully consider the options available and choose the one that best suits their requirements.

How to Invest in Peer-to-Peer Lending

A financial advisor reviewing peer-to-peer lending terms with clients.

Investing in peer-to-peer lending can be a viable way to earn a return on your money by lending it to individuals or small businesses. Here are six basic steps to get started:

Research P2P lending platforms: As with any other financial investment, start by learning everything you can about this lending model. Evaluate your financial standing and select a trustworthy P2P lending platform that aligns with your investment goals. User reviews, ratings and the platform’s track record can help guide your decision.
Complete registration: Sign up with your chosen P2P lending platform. You will generally need to provide personal information, verify your identity and link a bank account. The platform may also assess your creditworthiness.
Assess your risk tolerance: P2P lending carries inherent risks, including the possibility of borrower defaults. Consider how much risk you are willing to take and how it fits into your overall investment strategy.
Diversify your investments: Avoid putting all your money into a single loan or borrower. Diversify your investments across multiple loans to spread risk. P2P lending platforms often offer automated investment options that can help you achieve this.
Set your investment criteria: Define your investment criteria, such as loan terms, credit score requirements, loan purpose and geographic location. The P2P platform typically allows you to filter and select loans that match your criteria.
Invest in loans: Browse the available loan listings and invest in loans that meet your criteria. You can typically start with a relatively small amount. When you invest in a loan, you’re essentially buying a piece of that loan.

In addition to these steps, you may want to monitor your investments regularly, reinvest earnings, stay informed about platform changes and manage tax obligations to maximize your potential return.

Because P2P lending presents both opportunities and risks, you may also want to begin with a small investment to get acclimated to the platform, and then gradually increase your investments as you gain experience and confidence in the process.

Bottom Line

A couple reviewing the terms of a peer-to-peer loan investment.

Peer-to-peer lending can offer attractive interest rates for borrowers and potentially higher returns and diversification for investors. But both should proceed with caution. Borrowers could pay additional fees and may not have the same protections as with traditional loans. And investors could lose their money if a borrower does not pay back the loan.

Tips for Investing

A financial advisor can help you make a short- and long-term investment plan that helps you reach your financial goals. They can also help manage your investments so that you remain on track to reach those goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
You may want to think about using SmartAsset’s free investment calculator to help you estimate what certain investment choices will do to your overall portfolio.