What is peer-to-peer lending?

How peer-to-peer lending works

P2P lending platforms connect individual borrowers and lenders through an online marketplace. Here, lenders offer loans to borrowers in exchange for interest, while the platform facilitates the process and makes it quick and easy for both parties.

For investors, peer-to-peer lending is one way to potentially earn a higher rate of return on liquid assets than a traditional savings account offers. By lending money to others and charging interest on that money, investors can accelerate their earnings in a passive manner.

Originating a peer-to-peer loan

Potential borrowers can apply for a peer-to-peer loan online or via an app. The application process involves a credit check. If everything checks out, the loan is approved, and the borrower will receive loan offers from interested lenders.

Once the borrower chooses a lender, they’ll accept the offer, agreeing to the terms of the loan, and the funds will be distributed. As the loan is paid back, lenders earn returns through interest payments made by borrowers on the loans they fund.

Here are the steps involved for a borrower in a P2P transaction:

• Apply for a loan, stating the amount needed (this often happens either online or via an app).
• Provide financial details such as income, debt, debt-to-asset ratio, etc.
• Undergo a credit check.
• Receive and review loan offers based on eligibility criteria.
• Accept one of the loan offers and agree to the repayment terms and conditions.
• Receive funds.

Here are the steps involved for a lender/investor in a P2P transaction:

• Set up an account on a P2P website or app.
• Review loan listings.
• Make offers to attractive listings.
• Allocate funds to selected loans.
• Earn interest as the borrower repays.

Benefits and risks of peer-to-peer lending

The major benefit of peer-to-peer lending is the reduced hassle both parties enjoy as a result of a less formal, more streamlined approach to borrowing and lending. Without a bank stepping in, the transaction involves fewer regulations — and less legwork.

P2P transactions usually take place entirely online, often through a mobile-friendly app, which means they can occur at any time and in any place — they often happen on the go. Many investors prefer this fast-paced, efficient way of conducting business.

There are some risks involved for both parties, however. Below, we’ve outlined the advantages and risks of peer-to-peer lending for both the borrower and the lender.

P2P borrower advantages:

• Lower interest rates: In some cases, borrowers can get lower interest rates than a traditional bank loan would offer.
• Credit score variability: Some, though not all, P2P loans offer greater leniency when it comes to credit scores. This allows those with marginal scores to obtain a loan.
• No restrictions on use: P2P loans can be used for any purpose, from purchasing a car to paying down medical debt or school loans. Borrowers are not required to indicate what the loan will be used for.

P2P borrower risks:

• Less lenience for default: P2P lenders are often much less forgiving than a bank or traditional lender in the event you can’t repay the debt. Some will report the debt to a collection agency as soon as you’re 30 days late.
• Fees: There are often fees associated with P2P lending, like origination fees, late payment fees and other charges. Be sure to read the fine print before moving forward.
• Interest rates for lower credit scores: If you’re a borrower seeking a P2P loan with fair to poor credit, you might receive a loan offer, but the interest rate will likely be very high.
• Due diligence is required: Carefully research the P2P platform you’re considering to avoid predatory lending.

P2P lender advantages:

• Higher rate of return: Lenders can often use liquid assets for P2P loans and get a much higher rate of return than they’d get if the money were sitting in a regular bank account.
• Ease of use: P2P lending apps are streamlined and easy to use.

P2P lender risks:

• Borrower default: If the person you lend money to defaults on the loan, you stand to lose your own money — or to spend additional money trying to collect from the borrower.
• Platform insolvency: There’s a certain amount of risk involved when using an app, since you’re depending on the app or institution to remain solvent and operational.

As an investor, you can mitigate P2P lending risks by diversifying investments, conducting due diligence on borrowers and investing in platforms with strong credit assessment procedures, Bob Bilbruck, CEO of Captjur, a strategic consulting firm, told us.

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Types of peer-to-peer loans

You can obtain a peer-to-peer loan for just about anything. P2P loans are often personal loans, but business, real estate and school loans are also common, Bilbruck explained.

The interest rate you receive is based on the type of loan you’re seeking (business loans often have higher rates to reflect the higher risk involved, for instance). P2P personal loans may have more competitive rates and are based on creditworthiness, Bilbruck told us. The kind of loan you’re seeking might also inform which platform you should use — some specialize in particular loan types.

Tax implications of peer-to-peer lending

If you’re considering a foray into the world of peer-to-peer lending, it’s wise to consider the tax implications you might face. As a lender, you’ll be required to pay taxes on any interest income you collect from P2P lending in a given year. This income should be recorded on your tax return as “interest from other income.” Some fees can be deducted to offset this amount.

If you find yourself in the unfortunate situation of losing capital from a P2P investment, you can deduct this amount as a capital loss on your tax return, which reduces your taxable income. You’ll use Schedule D to report these losses. Use Schedule B for interest income, Bilbruck advised.

Borrowers using P2P funds for qualified business expenses can sometimes deduct the interest paid on the loan when tax time comes around.