P2P Lending: What Is It & How Does It Work?

Peer-to-peer (or P2P) lending has been kicking around since the mid-2000s, with a growing number of platforms available to consumers every year. According to a survey by ASIC, the 2016/2017 financial year saw $300 million in loans written through peer-to-peer platforms in Australia.  So, what is it and how does it work? Our friends at Canstar share their knowledge on the topic.

 

What is P2P lending?

 

P2P lending, also known as marketplace lending, is one of the earlier examples of the sharing economy in action, having started back in 2005. While many people associate sharing economy businesses in Australia with getting driven around or helping you find somewhere to stay on holiday, the idea behind P2P lending is to provide an alternative platform to connect finance-seeking consumers with a lender.

 

P2P lending is an online finance platform that cuts out the middleman (your traditional lenders such as a bank, credit union or building society), to allow people to borrow funds directly from investors, who can be individuals or corporations. The platform itself typically makes money through charging fees to the consumers and investors.

 

A P2P loan can generally be used for a variety of reasons including personal loans, home loans, business funding and property development.

 

How does P2P lending work?

 

P2P lending generally operates within 'lending marketplaces', where investors and borrowers are matched based on compatibility between their respective goals and interests. The lender usually takes a share of a pool of loans assembled to reflect a particular risk range, maturity profile, loan size and other relevant criteria, and of course interest rate. This means significantly lower risk than relying solely on a single loan for repayment.

 

The risk assessment of the borrower will determine the interest rate – the higher the assessed risk, the higher the rate paid. This means that investors can mix and match their exposure amongst different loan pools to fit with their risk/return profile.

 

Different P2P platforms have different focuses based on general loan size. However, they tend to operate using similar frameworks, in which investors and lenders sign up to the online platform, and are then matched.

 

Generally, both the potential borrower and investor register, with a series of security measures including ID checks to ensure compliance with industry standards such as Anti-Money Laundering and Counter-Terrorism Financing.

 

The way P2P marketplaces manage the matchmaking process varies - with some there are “off-the-shelf” style options while others connect parties within an auction-like setting. Either way, we’re increasingly seeing technology play a key role where investor risk preference is matched with suitable borrowers.

 

What is the history of P2P lending?

 

P2P lending began in 2005, with the launch of UK-based P2P platform Zopa. Prosper and Lending Club started in 2005 and 2006 respectively, and were the first two P2P lenders to launch in the US. P2P lending has been available in Australia since 2012.

 

The last decade or so has only seen P2P lending get bigger, and more or less become the spearhead of the alternative finance - or 'alt-fi' - movement.

 

While the combination of no limitations on amounts of money  and little to no industry regulation in some countries has seen P2P lending run into some issues - it's not legal in a handful of US states and China recently announced a crackdown on its booming P2P marketplaces - P2P lending continues to grow in popularity globally.

 

Who may benefit from P2P lending?

 

P2P lending can enable prospective borrowers to access funding that could potentially come with a lower interest rate and costs.

 

Prospective lenders can in turn be given the opportunity to diversify their portfolio of investments. They can choose to lend different amounts to different individuals, who may have a range of risk profiles. Generally, the riskier a borrower is, the higher the interest rate the investor can seek on the loan.

 

What are the risks of P2P lending?

 

Despite its potential benefits, P2P lending isn’t always a smooth process, and can pose a few risks to both the borrower and the lender.

 

Supply and demand isn’t guaranteed. In fact, some P2P platforms still need to raise wholesale funds to meet the undersupply of investors. While a financial institution is generally in the position to assess you for a loan, the ability to leverage a P2P lending platform depends on there being an investor willing to lend you money, and that may not always be the case. On the flipside, there may not always be a borrower there to take your money.

 

From the lender’s perspective, P2P lending is higher risk than bank deposits. In the latter case your recourse is against the bank’s balance sheet assets, and authorised deposit-taking institutions (ADIs) have federally guaranteed protection for deposits below $250,000. In the former, you are limited to your share of the pool of loans you have invested in and a reserve for loan write-offs set aside to support that portfolio.  

 

Of course, you expect a better return on your funds than bank deposits offer, and according to ASIC, the number of complaints received by providers in the last financial year was generally low.

 

It's worth noting that P2P lending is an online venture. If you're not comfortable with taking out a loan online, P2P lending may not be for you. However, the online-only business structure can have benefits - no brick-and-mortar locations can mean lower costs for P2P platforms, which could be passed on to lower costs for customers.

 

At the end of the day, P2P lending is still a relatively niche part of the financial services landscape and it isn’t a suitable finance option for everyone. However, it is undeniable these platforms are meeting a growing consumer demand to access finance outside of the traditional channels.

 

If P2P lending is something that interests you as an investor, it’s important to give the product disclosure statement a thorough read before signing up for any platform or service.  If in doubt, seek advice. From a borrower’s standpoint, always compare the offering with what might be available to you through traditional sources.

 

Stephen Mickenbecker

 

Steve Mickenbecker is the Group Executive Financial Services at Australia’s biggest financial comparison site*, Canstar. He has decades of experience in the finance sector, is a wine connoisseur and is passionate about helping consumers make informed decisions with their personal finances.

 

 

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