What is peer to peer lending?

Peer-to-Peer Lending: What Is It and How to Compete

Online banks are not the only competition born out of the Internet retail lenders are facing today. Peer-to-peer lenders have emerged as another rival. So what is peer-to-peer lending? Borrowers post loan listings stating the amount and purpose of the loan they need. Investors review loan listings and invest in those meeting their criteria. Peer-to-peer lenders act as middlemen between the borrowers and investors.

Just like traditional banks, peer-to-peer lenders make money on the spread. For example, the peer-to-peer lender may pay 6 percent on the funds provided by the investor and charge 8 percent on the funds lent to the borrower. Once the loan is funded, borrowers make monthly payments to the peer-to-peer lender, which in turn pays a portion of the payments to the investor.

Unlike traditional banks, peer-to-peer lenders do not incur risk. Investors assume the risk related to the loans and take the loss if the borrowers default. The peer-to-peer lenders assign interest rates based on the risk factors associated with their various loans. It is up to investors to decide how much risky they are willing to accept. The higher the risk is, the higher the rate of return.

Some companies have expanded upon the basic peer-to-peer operating model.
They now offer an approach that is more similar to a traditional retail lender. Investors provide funds (dare we say deposits) and indicate the risk level they are willing to accept. The peer-to-peer lender reviews the loan listings and matches them with investor criteria. After identifying a match, the peer-to-peer lender makes the credit decision, disburses the funds, and “services” the loan. Losses are spread across the group of investors within a given risk range. And yes, they use scoring models and every other modern tool used by today’s retail lenders.

Sound like a bank? Regulators think so. Therefore, peer-to-peer lending companies must comply with federal regulations, such as the Equal Credit Opportunity Act, Fair Credit Reporting Act, and Electronic Funds Transfer Act. In addition, they have to follow SEC rules on the investor side.

Both borrowers and investors benefit from the peer-to-peer lending model. Investors receive true risk-adjusted returns and access to a high yield investment class (traditionally reserved for institutional investors) in investment increments as low as $25. Borrowers receive lower interest rates on average than those charged by traditional banks and have easy access to an online platform to get funds quickly.

Should traditional retail lenders be worried? Yes. Peer-to-peer lenders are a competitive rival with their ready communication system in place (the Internet) and reduced infrastructure expenses. Yet, traditional banks have an advantage over peer-to-peer lenders – their brick and mortar branch network. Traditional lenders are in the markets where customers work and live. Customers can walk in and talk with a person face-to-face. Peer-to-peer lenders can’t offer or compete with that. Remember that most people feel more confident and secure when they can visit their bank and speak with their banker in person. Take advantage of that huge edge you have over your peer-to-peer lending rivals.