How Do Peer-to-Peer Loans Work? The Complete Guide

When you’re looking to borrow money, your first thought may be to head straight to the bank. But you could be overlooking another option — a peer-to-peer loan. This innovative lending alternative has grown increasingly popular over the last decade. And it may offer you advantages over traditional loans and financing.

What Is a Peer-to-Peer Loan?

The peer-to-peer lending industry, also known as P2P, is fairly new on the financial scene. Prosper (in 2005) and LendingClub (in 2007) were established early in the U.S. peer-to-peer market and continue to thrive as two of the largest lending platforms in the country.

[Read: The Best Personal Loans of 2018.]

Lending platforms are where borrowers and lenders typically find each other for P2P lending. These platforms handle the legal and financial end of the transaction, including setting up your loan terms, delivering the loan amount to the borrower and disbursing appropriate repayments to lenders.

Peer-to-peer loans may look like many bank loans, with some marketplace lenders offering fixed interest rates on loans as large as $40,000 to $50,000, with terms ranging from three to five years. But unlike a traditional loan, peer-to-peer loans aren’t necessarily supplied by a bank. Instead, the cash comes from one or more investors. These investors look to earn a return on their money by allowing you to borrow it for a period of time and then earning interest from you.

Their objectives and tolerance for risk can vary widely. Some may be looking for a big payout, others a nearly sure thing and still others a cause to support, such as a young family buying its first home or a mission-oriented small business just getting off the ground. And all investors assume at least some risk in trusting that you’ll make good on your promise to pay in full.

So who are these investors? Steve Allocca, president of LendingClub, notes that, early on, the peer-to-peer name was true in the strictest sense for LendingClub. “One hundred percent of the loans originally were funded by noninstitutional retail investors: individuals who’ve accumulated savings and want to take a part of those savings and invest them directly in a portfolio of consumer loans.”

But he adds that individuals currently provide cash for only about 10 percent of the $10 billion in loans funded this year at LendingClub. The other 90 percent comes from financial institutions.

How a Peer-to-Peer Loan Is Different From a Traditional Loan

If you get a bank loan, the bank does all the heavy lifting: It processes your application, specifies the loan options for which you qualify, provides the full amount of the loan and accepts repayment.

With a peer-to-peer loan, however, the P2P lender handles the logistics but doesn’t provide the cash. Instead, investors provide the money for your loan. And they expect to be repaid by you — through the lending site — with interest.

Peer-to-peer loan amounts for individuals generally go as high as $40,000 to $50,000, while P2P business loans can max out at about $300,000 to $500,000. As with other loans, you’ll have to repay not only the principal (the amount you borrowed) but also interest and fees.

[Read: The Best Small Business Loans of 2018.]

Peer-to-peer loans generally feature an origination fee, which can be 1 to 8 percent of the loan amount. In fact, you’ll generally find that the origination fee must be paid upfront. So, a loan of $20,000 with a $1,000 origination fee will mean that only $19,000 is paid out to you.

The Appeal of Peer-to-Peer Loans

Peer-to-peer loans are used for many of the same purposes as those that come from traditional lenders, including buying a car, paying off high-interest debt, consolidating multiple sources of debt, covering home improvement costs or funding a business. But there are certain features and advantages that make peer-to-peer loans enticing to some borrowers.

First, there’s the convenience factor. Peer-to-peer lending typically takes place online. Michael Funderburk, director of personal loans at LendingTree, notes that you can skip the bank branch, deal with less paperwork and finish your application in just a few minutes.

And Ryan Guina, founder of finance websites Cash Money Life and The Military Wallet, adds that peer-to-peer loan interest rates may be lower than standard credit card rates. P2P loans also could be competitive with loans you’d qualify for from a traditional lender, if you have top-notch credit.

Peer-to-Peer Loan Downsides

Of course, a peer-to-peer loan might not feature the lowest interest rate for your circumstances. In fact, if you’re a high lending risk, you might end up on the upper end of the scale, with APR offers as high as 36 percent.

Plus, you’ll generally need to demonstrate at least fair credit history to qualify. With most P2P lenders, this means having a FICO score of at least 600 to 640. And investors will likely shy away from you if you’re already buried under debt or can’t show a history of consistent employment.

Guina cautions that, as with any type of loan, peer-to-peer loans aren’t a cure-all for money troubles. “You still need to change your spending habits and work toward eliminating all your debt. Simply consolidating a loan to pay off your current credit card debt — only to run it up again — is a recipe for financial disaster.”

What Happens When You Apply For a Peer-to-Peer Loan

Funderburk says the application process generally involves a digital application with just a handful of questions. Expect to share basic financial information like your current income, the amount you want and why you’re looking to borrow. Depending on your lender and the level of risk you present, Funderburk adds that you may be asked to provide income verification or even participate in a phone call for risk assessment.

If you’re approved for a loan, you’ll find out quickly, often within a few days. You’ll be presented with a number of loan options with varying terms, including the amount borrowed, APR, fees and monthly minimum payment amount.

Once you sign your loan contract on the (digital) dotted line, you can generally expect quick disbursement of the loaned amount to your bank account — within days. In general, that same account will be used for automatic, fixed monthly payments of your principal, interest and fees.

What Are Your Alternatives If You Need a Personal Loan?

With all lending products, it’s essential that you explore your options and assess your financial circumstances before committing to a loan. Here are some other choices to consider, alongside P2P, if you need a personal loan:

A conventional loan from a brick-and-mortar financial institution. Check with banks and credit unions about their personal loan options and qualifying criteria. You’ll find a wide array of structures and terms available. Large brick-and-mortar institutions may also offer face-to-face counseling to discuss your financing options.

A conventional loan directly from an online lender. If you want a traditional personal loan without a trip to the bank, consider working with an online lender. From the convenience of your home, you can submit your application and supporting documents, get approved and receive funds electronically.

A home equity loan. If you’ve accumulated equity in your home, you may be able to tap into it as a source of funds. Look into the pros and cons of home equity loans, home equity lines of credit and reverse mortgages. But watch out. These types of loans are secured by your home. “These should only be used when necessary,” says Guina. “Failing to repay a home equity line of credit could put your house at risk of foreclosure.”

[Read: The Best Bad Credit Loans of 2018.]

A credit card. You may want a personal loan to refinance credit card debt. But, if you’ve got a killer credit score, you may actually be better off paying that debt with another credit card — specifically, a zero percent introductory APR balance transfer card. These cards typically offer that promotional rate for no more than a year or 18 months, but that time may allow you to save on high interest costs and pay down existing debt.

Even if you can’t do a balance transfer, if you have plastic in your wallet, you can still use it to finance expenses. Just be sure to check your card’s interest rate first because you might end up paying a higher interest rate. And consider the impact on your credit, since using a large chunk of your available credit limit can drag down your FICO score.

A different peer-to-peer loan. Finally, you can shop different peer-to-peer platforms to find your best option. Several reputable P2P lenders exist, and one may offer you better loan terms than another.

If you’re having trouble getting a good interest rate, there are steps you can take. For instance, Allocca says that you may be able to sweeten your application if you apply jointly with a co-borrower with good credit and income. Additionally, if you’re considering a P2P loan to knock down credit card debt, your lender may be willing to give you a better APR if you authorize it to pay your creditor directly.

More from U.S. News

Can You Refinance a Personal Loan?

The Difference Between Interest Rate and APR

What Is a Credit-Builder Loan (and Should You Get One)?

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