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Red flags of peer-to-peer lending

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Peer-to-peer lending, or P2P, came about in the early 2000s as an alternative lending option. Today, this type of lending has more regulations than it did in the early days, but there are still questions about the best ways to protect both lenders and borrowers for this type of loan.

Despite debates about regulations, being directly connected over the Internet to a pool of lenders willing to back all or part of a loan can be a helpful alternative to more traditional lenders. Plus, it offers an opportunity for individual lenders, also called investors, to make some possible extra money.

Not all peer-to-peer lending companies are created equal, and the burden of due diligence sits squarely on the shoulders of prospective borrowers and lenders.

What is peer-to-peer lending?

P2P lending is a way for prospective borrowers to borrow from other individuals rather than banks or financial institutions. This lending option offers borrowers another option when looking for a lender.

P2P lending typically takes place through online platforms. These online platforms act as a liaison connecting borrowers and lenders. There are many different P2P lending sites, and borrowers can find sites that cater to their specific loan needs. Some sites cater to those who need help with medical costs while others are targeted at small business owners.

“There are several major P2P lenders, such as Lending Club and Prosper, and many smaller companies jumping on the bandwagon,” says Ryan Guina, founder of CashMoneyLife.com. “Bigger doesn’t always mean better, and smaller doesn’t mean worse. But, there are advantages to using the more established platforms, including a more highly regulated process and a larger investor pool, which makes it more likely your loan will be funded.”

Why do some people want a peer-to-peer loan?

There are many great reasons both borrowers and lenders may want to try peer-to-peer lending. P2P loans may be just the right alternative for certain borrowers.

For borrowers with good credit scores, P2P lending often offers lower interest rates than traditional banks or lending institutions. If borrowers don’t have great credit, P2P lending may allow them to get a loan when a bank might not approve them for one.

Lenders for P2P loans may be enticed by the high returns they can make compared to other investing options. Typical returns for P2P investors per year average at about 5-9 percent while some investors see returns as high as 10 percent or more.

Red flags in peer-to-peer lending for borrowers

Borrowers may find P2P lending to be a great option if they are short on cash, but there are some red flags to look for if you are thinking about applying for a P2P loan. Borrowers should make sure they are using a reputable lending platform and plan accordingly if they encounter any of these red flags.

Borrower may need to pay additional fees

“If you’re fed up with bank fees, you’ll really hate P2P loans,” says Howard Dvorkin, CPA and Chairman of Debt.com. “On top of the interest rate you’ll pay, there’s the origination fee, which can be as low as 1 percent but as high as 8 percent. That’s much more than a bank or credit union will charge you for a personal loan.”

Borrowers may get worse rates than with traditional loans

P2P loans can sometimes have lower rates than traditional loans, but borrowers should do their research. You can often get similar or lower rates with a traditional lending institution.

Dvorkin says that it can be tricky to figure out if rates will be lower. He says that P2P loans are often marketed to have lower interest rates than traditional lenders, “But it’s actually hard to tell. Is a particular P2P loan really cheaper than your credit union if you have a decent credit score? Especially after you factor in the fees? There’s no easy answer.”

Make sure you run all of the numbers before deciding which option is cheaper for you.

Less support if there is difficulty paying the loan

If a borrower is unable to pay off a loan within the originally agreed terms, lenders have a right to fight for their money back. A traditional bank might offer support such as a payment plan or a longer period to pay back the loan before sending a loan to collections or pursuing legal action. However, peer-to-peer lenders may send a defaulted loan to a collection agency in as little as 30 days.

If your payments are late, a P2P lender may also start to raise interest rates or add fees. If you plan to borrow using a P2P loan, make sure you know the terms you are signing up for. A traditional lender could be more lenient with an unpaid loan, but a P2P lender will likely take action against a defaulted borrower more quickly.

Red flags in peer-to-peer lending for lenders

Lenders also face some potential hazards in peer-to-peer lending. If you are interested in becoming an investor in P2P loans, you can have significant returns for your investment, but you should also know the risks you assume when you become a lender.

If the borrower defaults, lenders often lose their money

While some peer-to-peer loans are secured, they are most often unsecured loans. This means the borrower isn’t borrowing against any collateral, and if they can’t pay their loan the lender loses their money. Whatever money the borrower hasn’t paid back will be lost.

Loans are not typically FDIC insured

The Federal Deposit Insurance Company (FDIC) is an agency formed by Congress to protect and insure financial transactions in the United States. A traditional loan with a traditional bank is FDIC insured, but many P2P loans are not. Unless funds are deposited in a bank insured by the FDIC, a P2P loan may not have this extra layer of protection.

Returns may be lower for the lender if the borrower pays early

As the borrower pays back the loan, the lender gets their money back. This money stops earning interest once it is paid back. If the borrower pays back the loan early, the lender earns interest for a shorter period of time. This means lower returns for the lender.

Lenders should be cautious of this. Choosing to continually reinvest the money that is paid back will help them to get the highest returns in P2P lending.

Bottom line

P2P loans can be a great option for both borrowers and lenders, but both should consider all of their options thoroughly when deciding what is best for them. “P2P loans are affordable tools when used correctly. But like a power saw, if you’re not paying close attention, you can lose something very valuable to you,” says Dvorkin.

Borrowers should watch out for extra fees or rates that are comparable to other lenders. P2P investors need to be aware of the financial risks they are taking and understand the returns they may receive compared to other investments. Ultimately, P2P lending can be a great option for both in the right situation.

Written by
Emma Woodward
Contributing writer
Emma Woodward is a former contributor for Bankrate and a freelance writer who loves writing to demystify personal finance topics. She has written for companies and publications like Finch, Toast, JBD Clothiers and The Financial Diet.
Edited by
Loans Editor, Former Insurance Editor