What Is Peer-to-Peer (P2P) Lending? Definition and How It Works

What Is Peer-to-Peer (P2P) Lending?

Peer-to-peer (P2P) lending makes it possible for individuals to obtain loans directly from other individuals, without going through a bank or other financial institution. The proliferation of websites that facilitate P2P lending in recent years has greatly increased its adoption as an alternative method of financing.

P2P lending is also known as "social lending" or “crowd lending." Major players in the field include such platforms as Funding Circle, Kiva, LendingClub, Prosper, and Upstart, among others.

How Peer-to-Peer Lending Works

P2P lending websites connect individual borrowers directly to individual lenders. Each platform sets its own rates and terms. Most sites have a wide range of interest rates based on the creditworthiness of the applicant.

Typically, the process works like this: The investor will open an account on the site and deposit a sum of money to fund their loans. Loan applicants will post a financial profile and be assigned to a risk category, which affects the interest rate they will have to pay to borrow.

The applicant may then receive loan offers from one or more investors and accept one of them. (Some applicants break up their requests into chunks and accept multiple offers.) The money transfer to the borrower and the monthly loan payments to the lender are handled through the platform. The process can be entirely automated, or lenders and borrowers can choose to haggle.

Some sites specialize in particular types of borrowers or loans. Funding Circle, for example, focuses on small businesses. Kiva, a nonprofit, allows investors to support entrepreneurs and others in the U.S. and around the world, many without access to traditional lending institutions. LendingClub has a "Patient Solutions" category that provides loans and payment plans for medical and dental care.

History of Peer-to-Peer (P2P) Lending

P2P lending, in its present form, dates back to 2005. Early on, it primarily provided access to credit for people spurned by conventional financial institutions and for students who wanted to consolidate their loan debts at a more favorable interest rate.

In recent years, however, P2P lending sites have expanded their reach. Many now target consumers who want to pay off their credit card debt at a lower interest rate. Home improvement loans and auto financing are also available at P2P lending sites.

The interest rates for applicants with good credit are often lower than comparable bank rates, while rates for applicants with sketchy credit records may go much higher. LendingTree.com, for example, listed personal loan rates at several different peer-to-peer sites ranging from slightly under 8% to nearly 36% in August 2024. For comparison purposes, the Federal Reserve's latest published data on consumer credit (which reflected May 2024 numbers) showed average interest rates of 21.5% on credit cards and 11.9% on 24-month personal loans.

For the individuals who supply the money, P2P lending has become a way to generate interest income on their cash at a rate that exceeds those offered by conventional savings accounts or certificates of deposit (CDs), although it lacks the government guarantees that those generally offer.

The Risks of Peer-to-Peer Lending

People who wish to lend money through a P2P site need to consider the possibility that their borrowers will default on their loans. Research on P2P lending platforms has indicated that defaults are much more common than at traditional financial institutions, sometimes in excess of 10%.

By comparison, the Federal Reserve's index of delinquency rates on all loans at all commercial banks shows that since 1986 delinquencies have never exceeded 7.5% (in Q1 2010) and stood at just 1.44% as of Q2 2024.

Any investor considering P2P lending should also check the site's transaction fees. Every platform makes money differently, but it may charge fees or commissions to the lender, the borrower, or both. Like banks, the sites can impose loan origination fees, late fees, and bounced-payment fees, among others.

Frequently Asked Questions (FAQs)

The Bottom Line

Peer-to-peer lending sites offer borrowing options for entrepreneurs, small business owners, and other individuals who might not fit the profile of the ideal loan recipient by traditional banking standards. While P2P lenders may extend credit more easily, it comes with higher fees and interest for borrowers and a higher risk of default for lenders. Many P2P platforms make it easy to invest or borrow, but it's worth reading all of their terms to learn about the costs before signing up.