Peer-to-peer (P2P) lending is the crowdsourcing version of borrowing money. If you’re a small, growing business without much history, borrowing from your peers can be a great alternative to borrowing from the bank.
Conversely, if you’re looking to lend, P2P loans can be a great way to make a buck while helping out a small business.
This system aims to increase profits for lenders and decrease restrictions on borrowers by kicking the traditional middlemen (bankers) out of the system.
Fundamentally, the system is almost identical to traditional lending, though the major players are slightly rearranged.
We’ll take a look at how peer-to-peer lending works and some of the risks and benefits that come with using it. But first, let’s look at a how banks normally operate to understand the basics of borrowing.
How banks lend money
Interest rate spreads—the difference between how much a bank pays you for your savings and how much it charges you for borrowing—have been the backbone of banking since 2000 B.C., give or take. It’s banks’ differing risk profile that allows them to manipulate that difference, something P2P lending seeks to circumvent.
Due to their low perceived risk, banks can offer you $1.15 a year for holding on to $100 of your cash. After all, it’s not like you take any real risk putting money in a bank. The bank certainly isn’t going to go out of business, right?
You, on the other hand, are like an intoxicated wild boar, let loose behind the wheel of a semi during rush hour. You are risk personified and will be charged between $6 and $20 per year for borrowing $100.
You can already see how this model makes money. Banks take the $100 that Jim deposits in his account and lend it to you. They pay Jim $1.15 and charge you $15.25, pocketing the $14.10 difference.
P2P lending asks, “What if Jim just gave you the cash directly?”
The peer-to-peer model
Peer-to-peer lending is just one of many peer-to-peer relationships that have cropped up in the last decade. The most famous P2P model exists in the file sharing community, where torrents have been making cable TV look silly since the early 2000s.
With P2P systems, you break a single product into a bunch of smaller, constituent parts. These smaller parts are both more manageable and easier to move around.
You then connect one person who needs part A with someone who has part A. The person in need may also need part D, but could source that bit from another person.
For example, a file can be broken into millions of structured, small packages. I can look at the structure of the file and ask you for the first bit, your neighbor for the middle chunk, and a guy in Bangalore for the last piece.
Because my computer can manage multiple downloads at once, I can take all those pieces in faster than I could if I had to download one file from a single place. I also decrease my risk. If you go offline in the middle of the process, I can just ask someone else to jump in where you left off. In a traditional system, I’d be stuck until you came back.
Peer-to-peer lending offers similar benefits. By giving $25 to four people, all of who need $100, I spread out the risk that all of my loans will be defaulted on. The borrower benefits by being able to raise more capital than any one person could provide.
Benefits of P2P lending
Compare the peer-to-peer model to the classic banking model. In effect, the same thing is happening; a group of people are pooling resources and others are borrowing from that pool. The differences are in the structure of the pool and the steps required.
Benefits for lenders
By putting money directly into a loan, lenders can generate much higher returns than they would see from a bank. Instead of entering into a blind contract with the bank, I’m giving cash directly to a borrower, so I can be the one tapping into the interest rate spread.
It also means that I’m not tied to one financial institution. My cash can generate more cash in a diverse manner, spreading the default risk out to a bunch of smaller parties instead of lumping it all in with Wells Fargo or HSBC.
Finally, it means I have more control over what I finance. Your bank lends money to people that you do not like, or at least to people who do things you don’t like. Whether that’s building bombs or baking donuts, your savings is likely supporting a lot of unsavory strangers.
With P2P lending, on the other hand, you can back projects that make you feel all shiny and good inside.
Benefits for borrowers
Borrowers get to avoid the hoops and hurdles associated with banks. Five forms of ID, in triplicate, notarized, and a pint of blood are requirements of the past.
Instead, basic transparency and simplified forms are the P2P norm.
Borrowers can also skip out on many of the normal restrictions banks place on them. Showing a profit, three years of tax returns, and other requirements that often seem to punish new businesses are now avoidable.
And, similar to lenders, borrowers can decrease their reliance on any one bank. Instead of owing money to a faceless organization, you can owe it to a dozen real people.
The risks of P2P lending
Peer-to-peer lending has all the normal risks of borrowing and lending, but those risks are amplified. The reason the bank doesn’t pay you much for your savings account is that, all things considered, it is a pretty low-risk system.
Risks for lenders
The FDIC says 553 banks have defaulted since 2000. Of those, just 31 weren’t acquired by some larger institution. Meanwhile, almost 800,000 people filed for bankruptcy in 2016—and that was a good year.
You are much, much riskier than a bank. The reason a lender will get more interest with a P2P loan is that there aren’t as many controls and hoops to jump through, making P2P loans much riskier than investing in a bank savings account. Banks make borrowing difficult on purpose, because they like making the safest possible risky bets.
Risks for borrowers
Borrowers will also find out that this isn’t the Wild West. You can’t get cash with a horrible FICO score, though there is more flexibility. (P2P loans are all managed by third parties, they just aren’t banks.) As such, you could spend a lot of time prepping and looking for the right platform, only to find out that no one is willing to take you on.
While not completely analogous, peer-to-peer lending is something like stock picking.
- Putting your money in a bank is like investing in an index tracking account—you’ll make money, but you’re not going to triple your cash overnight.
- P2P is a little more like investing in a single stock—you can make a good deal more than in a tracker, but the risk is significantly higher.
I alluded to the middlemen in the P2P world above. Lending platforms exist to take care of the paperwork and do some vetting. Unlike banks, these platforms don’t take in cash and then dole it out. Instead, they act as a centralized lending location.
Borrowers can list their loans, upload supporting documents, and access cash using the platforms, while lenders can receive payments and see what’s available. The platforms just facilitate the peer-to-peer relationships.
Most platforms will require you to be an “accredited investor,” which the SEC defines as someone with over $1 million in net worth (can’t count your house) or over $200,000 in annual income.
If you don’t fall into those categories and want to invest, check out the rundown of retail-investor-friendly, peer-to-peer platforms Lend Academy has put together.
Is P2P lending right for your business?
You need cash to start and grow your business. If you don’t have access to traditional lenders, don’t have the history to make banks happy, or just love the idea of borrowing from the Little Guys, peer-to-peer lending could be your salvation. The risks are real but manageable, and there are plenty of benefits to the system.
If you’ve got a well established brand with a history of growth, you may find your bank can offer you better rates than the P2P model. You may also have a great relationship with your bank, in which case, going the traditional route might be best.
Finally, if you need a bunch of cash for a more theoretical program—think Silicon Valley entrepreneur—you might consider one of the many other funding systems available.
For more funding insights and tips for picking the right financial management software for your business, check out Capterra’s finance blog.
Looking for Financial CRM software? Check out Capterra's list of the best Financial CRM software solutions.