Tuesday 18 September 2018

What is Peer to Peer Lending?

Before you start investing in anything, it is important to know what you are getting into.  For me it was about understanding what was peer to peer lending (P2P lending) was before making the decision to invest.  Below is my interpretation of what P2P lending is and how it works.  Explaining it to my wife the first description that came to me was it was like crowd funding a loan which is paid back with interest.

Put simply P2P lending at its core is people who have money, lend to people looking to borrow.  This is facilitated through a financial service provider (also known as a market place) which matches a borrowers request to willing investor/s prepared to fund the loan.  I’ve represented this relationship in the diagram below. 

Basic concept of Peer to Peer lending
Each month (or whatever the agreed payment frequency is) the borrower pays back principle and interest to the investors via the market place facilitator.  This is an oversimplification of the process so let’s go into a bit more detail of each of the three players: the borrower, the financial service provider and the investor.

The Borrower – This one is straight forward.  It is anyone from an individual to a company wanting to borrow money.  They approach the financial service provider instead of going to a traditional bank and apply for a loan.  The application process from here is the same with credit checks etc.   Once money is borrowed, it is paid back over the agreed time frame via principle and interest repayments as until fully repaid.

The Financial Service Provider – The financial service provider facilitates the loan.  They essentially run the logistics similar to a bank.  Items they cover off on are credit assessments to determine the suitability of the borrower and their ability to afford the requested loan, where its secured or unsecured, setting an interest rate based on the risk, handing the legal side setting up loan contracts etc.  On top of the general bank-like functions, the financial service provider links up investors who are prepared to fund a portion of the loan and handles the transaction of all money from the initial disbursement of the loan to the borrower and all repayments from the borrower to the investors for the life of the loan.

The Investor – The investor can be anyone from a company, trust or individual.  The list of people who can invest varies from different market place financial service providers with some restricted to essentially high net worth individuals / companies.  An investor can lend as little as $10 towards a loan, but again the minimum contribution amount varies depending on the provider.  Depending on the size of the loan there are potentially hundreds of investors contributing differing amounts to a single loan.

So why would people use Peer to Peer lending?
From a borrower’s perspective, they may achieve a lower interest rate than a traditional bank may offer.   On the flip side an investor may receive better returns on capital then cash in the bank, term deposits or other forms of investment.  The market place financial service providers make their money out of this typically through taking a cut of the interest the borrower pays over the life of the loan and potentially also loan establishment fees paid by the borrower.

I hope this has given you a better insight as to my understanding of peer to peer lending and how it works.  As with any investment, there are risks involved, my next blog will aim to breakdown what those risks are.

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