Advantages and Disadvantages of Peer to Peer Lending

Until fairly recently, if you needed a loan, the only real option was to talk to a bank or similar financial institution. But today, you can tap alternative sources of funding, including a peer-to-peer (P2P) loan, whereby individuals lend money to other individuals using a website as an intermediary. P2P lending, sometimes called social lending, crowd lending or even crowdfunding, also offers investors an alternative way to obtain a return on their money.

The P2P loan business began in the UK around 2005 and has since lent billions to UK businesses and individuals. The market is now established but is still seen by many as a niche option compared with traditional lenders.

How does P2P work?

P2P websites bring lenders and borrowers together. If you want to borrow money, you can either submit your requirements directly to one of the many P2P sites in the UK, or use a peer-to-peer loan comparison website, which will search the market to get you the best deal.

Your loan application will be assessed in the same way as an application to a traditional bank. The P2P loan platform will use a credit reference agency to trawl through publicly available information such as the electoral register, and will analyse your financial history to establish your credit rating, or the risk involved in lending to you. If your application is accepted it will then match you with other individuals willing to offer you a peer-to-peer loan.

If you’re interested in investing, in other words, becoming a lender, you can open an account on the P2P website and transfer across the money you want to invest. You may be able to choose the return you’re seeking and split your money across many borrowers, reducing the risk that a loan might not be repaid. Some sites even allow you to bid on loans.

Each platform will operate differently though, and offer different levels of protection to investors so it’s important to do your research to find the right option for you.

Generally speaking, the safer the investment is perceived to be, the lower the rate of return on offer for investors.

» MORE: Should I get a peer-to-peer loan?

Advantages for the borrower

• P2P sites can offer more attractive interest rates than banks and building societies – particularly if you have a good credit score.
• Some sites may offer peer-to-peer loans to people with lower credit ratings. They may also be willing to lend smaller sums than banks or building societies, which often have a minimum loan amount.
• Some platforms allow you to pay your P2P loan off early or make an overpayment with no penalties if you no longer need the loan.
• As the process is online, it tends to be quick and convenient.
• You can borrow money for a wide variety of purposes, including for business reasons.

Advantages for the lender/investor

• It may be possible to access a much higher rate of return than is currently available from other investments, such as deposit accounts or bonds.
• You can choose the level of risk you’re prepared to accept in terms of the profile of the borrowers you lend money to.
• Some sites have contingency funds to protect investors if borrowers default on loans.
• You can receive income from P2P lending tax free if you invest via an Innovative Finance Individual Savings Account (IFISA).

Disadvantages for the lender

• Loans you make are not covered by the Financial Services Compensation Scheme. So, if a borrower is unable to repay their loan, you will suffer a financial loss.
• If you want to get your money back during a loan agreement you are likely to have to find another lender to take on the loan. The platform can normally arrange this for you, but the process may not always be as quick as you might like. There may also be a fee.
• Returns may also be lower than expected if the borrower repays a P2P loan early.

Disadvantages for the borrower

• You may have to pay additional fees on top of the interest rate charged for the loan.
• You may have to pay a higher interest rate than that charged by traditional lenders if you have a poor credit rating. You may not even get a peer-to-peer loan if your financial profile is very poor.
• If you run into difficulties in repaying the loan, you might not receive the same protection as you would when borrowing through a traditional lender. A P2P website may, for example, pass on the bad debt to a debt collection agency, which could ultimately take you to court.

Alternatives

If you’re a borrower, you could try a traditional lender, such as a bank or building society, credit union, or in some cases your employer. If you’re having trouble borrowing money from a financial institution, you could ask a friend or relative to act as a guarantor. This means that they’ll be responsible for repaying the loan if you’re unable to do so.

» MORE: What type of personal loan is right for me?

Investors could consider traditional sources of income, such as deposit accounts, stocks and shares based investments, and government or corporate bonds.

Image source: Getty Images