What is peer to peer lending?

What is peer to peer lending Posted On
Posted By Eimantas

This is my firsts post in my new series about peer to peer lending, otherwise known as p2p lending. I will go into details about its pros and cons, overall market review, potential strategies and platform reviews. We shall begin the series with an introduction to peer to peer lending.

How does p2p lending work?

In short, peer to peer lending main principle is to skip the traditional middle man and introduce capital holders to people or business that need money. Traditionally that was done via banking. Capital holders would put their money into a bank as a deposit and gain interests for that. Meanwhile, the bank would look for anyone who is in need of money, for a mortgage, business investments or bigger purchases and would lend them money for much greater interests than it gives for a deposit. In this traditional scenario, it was the bank who took most of the risks with lending money. It had somewhat guaranteed to pay back deposit money. But there is always a chance that the debt won’t be repaid so it is the bank who takes the loses for bad loans. And the deposit holder is virtually risk-free. (You still can lose your deposit money in special scenarios, but those are rare.)

Then came peer to peer lending

So in peer to peer lending, capital holder basically acts as a bank, it is he who evaluates risk and chooses who to lend money and who to ignore. For this, he gets to keep higher interest rates, but he also is risking his capital. There is a chance that the debt holder will default and then it is unclear if the lender will ever get his money back. And it’s really hard to measure risk before lending money because you might lack proper information to evaluate it. Sure, you will see how much money a person is earning, how much debt he has, maybe his family status, gender, age. But depending on where your investment platform is located (country or state), there might be legal limitations on what information p2p platform can access. So there is a chance that potential debt holder lied about his information or at least withhold the bad parts from the lender.

Diagram showing how traditional banking and peer to peer lending works
In peer to peer lending scenario it’s the investor who is taking all of the risks

What is a p2p platform?

You can invest to peer to peer platforms just with your computer

Peer to peer lending would be hard if each lender would have to personally find every person to lend money. That would just take too much time and resources. And thus came p2p platforms. They work in the same way banks worked in the before described traditional model, but now they minimize risk themselves. All of the risks are outsourced to the capital holder. It’s his money that is at risk, the platform has 0 of its own capital lend out. So the platform looks for potential clients, that are in need of capital and introduces them to capital holders. If everything works out, and loan money is secured, usually most platforms take some sort of finders fee or a percentage of interest for themselves. And from mine experience looking into different platforms, most of the fees are paid by the person borrowing money, person lending money directly has no fees.

In short peer to peer lending platform connects the capital to people or business in need of it, takes a small part of interests and leaves all risks to the lender.

Types of peer to peer lending platforms

So far I personally saw only two types of platforms. General peer to peer lending platforms and real estate financing focused platforms.

General peer to peer lending platforms

Most famous of this type of p2p platform is US-based Lending club, but other platforms exist all over the world. From one country focused local players like personally used  and to larger European platforms like Mintos and Lenndy. Some of them focus just on personal loans, some just on business or both types. And platforms like Mintos and Lenndy focus on already existing loan financing made by private lending companies.

Real estate financing platforms

Real estate financing works basically the same way as general peer to peer lending, but it mainly focuses on real estate project financing. I am personally less familiar with this type of financing so I don’t know a lot about different platforms. But personally invested small part in platform just to test the waters, it’s also one of Lithuanian p2p platforms. I don’t know which platform the most famous, but the biggest platform that I know is based in Estonia.

Continue reading:

My 2018 portfolio review made up from p2p loans

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