What's Peer-to-Peer Lending? It May Not Be What You Think

As convenient as P2P loans can be, they are certainly not cheap.

Peer-to-Peer (P2P) lending allows borrowers to avoid traditional financial institutions and instead, deal with investors who might want to finance their loans. P2P is a growing alternative to traditional lending institutions. P2P lending is growing at a rapid pace, and according to Acumen Research and Consulting, expected to achieve a market size of $804.2 billion by 2030.

How it works

Let's say you have a great idea for a home-based business and need $20,000 to get it up and running. The problem is that your credit score is only so-so and you're not confident that a bank will loan you the funds.

You go online to visit a P2P lending site and fill out a loan application, which will likely include a credit check. The lending site lets you know if you're approved or not. If so, they'll tell you what your interest rate will be.

In the investors' hands

Using online software, the P2P site will match your application with potential lenders. And at this point, you sit back and wait as investors review your loan application and decide whether they want to fund it. An investor may fund a loan in its entirety or a portion of the loan amount. In other words, by the time investors have made their decisions, you may have money coming from several different sources.

Investor decisions are based on their goals. For example, one investor might want to play it relatively safe and loan as little as $25 to many borrowers. That way, their portfolio is a mix of higher-risk and lower-risk investments. The fewer risks an investor takes, the less they earn in interest payments. Other investors might go straight for risky loans in hopes of higher returns.

Repayment begins

If your loan is successfully funded, the money is likely to hit your bank account in less time than it would take a traditional lender to distribute funds. Now, it's time to move on to the repayment stage. Just like a traditional loan, you'll repay a P2P loan with regular monthly payments.

Each payment is divided between the various lenders. Let's say one lender decides to fund $10,000 of the $20,000 for which you applied. That lender will get 50% of each payment. The remainder will be split among the other investors.

Upside and downside

The upside of P2P loans is that you may be able to get a loan that you would not otherwise qualify for. The downside is that you're likely to pay a much higher interest rate than you would pay if you landed a loan through a traditional lender.

Before applying for a P2P loan, decide if you would be better off working to boost your credit score in order to qualify for a lower-interest loan.

Fees

There are costs associated with borrowing money through a P2P lending site. Some P2P sites include fees in the payments, while others require upfront fees of 1% to 8% or more. No matter how fees are built in, go over the loan contract with a fine-toothed comb before signing on the dotted line. Make sure you understand how much the loan is going to cost, including all fees and interest paid.

Ideally, the best personal loan is one that charges no origination fees and offers you a fair interest rate.