What is peer to peer lending and how does it work?
Peer to peer (P2P) lending involves borrowers taking out an unsecured loan via investors though the peer to peer lending platform, rather than borrowing from a bank or financial institution. The P2P platform facilitates the bringing together of private investors and private borrowers to transact together.
If a borrower has a shining credit rating, borrowers can actually get competitive rates. The concept is really an extension of a very basic loan strategy – loaning money to a friend or family member is an example of a small form of peer-to-peer lending. An entirely new lending industry has stemmed from this basic concept; matching people who need money with other people who are prepared to provide the loans via an intermediary peer to peer lending service. It is generally up to the peer to peer lending service provider to sort out the administration, managing repayments and interest repayments and chasing defaults. Make sure you study up on how much the service provider is going to take care of.
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Untangling the web of peer to peer lending
While peer to peer lending can operate in various ways, it is generally carried out via a website. Borrowers list their request on the peer to peer lending website and then the investor selects which loan they would like to invest in. The level of detail about the loan varies. Sometimes websites show specifics, such as the reason for the loan and how much interest they will pay. Lenders can then either lend the whole loan amount, or a portion. Or, the website may group up similar loan types, so investors are able to invest in multiple loans at once.
Financial risk management with peer to peer lending
Investing is a risky business and peer to peer lending requires some financial risk management – mostly for investors.
There aren’t any huge risks for borrowers in peer to peer lending. There are generally more borrowers than there are lenders so, if a borrower’s application is approved; they are likely to find an investor for their loan.
Financial risk management for lenders
On the borrower’s side, it’s great news if you’re in a position to pay back a loan earlier. But, if you’re the lender, a loan paid back early means missing out on earning more interest from the loan. Even worse, if a borrower defaults on the loan, then the investor may risk capital loss. Although, investors are rewarded for taking on that risk; the returns for investors are, in general, better than the interest they would receive from investing money in a term deposit or savings account.