What Is Peer-to-Peer Lending?

Peer-to-peer (P2P) lending, also known as “social lending,” is a somewhat newer option available for consumers to borrow money. This method of funding facilitates an easy, non-traditional way for borrowers to finance personal loans beginning with simply filling out an online application. Because P2P lenders, unlike traditional lenders, offer loans that are funded by ordinary investors, like me and you, instead of large banks the qualification standards for these loans are generally less stringent. As a result you might be able to qualify for a P2P loan even if you have been turned down for a personal loan at your bank due to credit or income verification issues.

Billions of dollars each year are currently being loaned to borrowers through P2P lending. However, as with any type of debt financing product you should always consider the pros and cons before you decide to sign your name on the dotted line. Here’s how it works.

Step 1 – You decide you want to borrow money, but not from a traditional lender like a bank.

Step 2 – You find a website that facilitates Peer to Peer lending, like Prosper or Lending Club.

Step 3 – You fill out an application and explain what you need the money for.

Step 4 – Investors decide if they want to invest in your loan and how much they want to invest. It’s not uncommon for many investors to cobble together the amount needed to fund your entire loan amount.

Step 5 – You get the money and start paying it back. At the same time the investors get paid.

The Upside

When used properly P2P loans can help you to improve your credit scores and perhaps even your financial situation as a whole. Many consumers who take out P2P loans do so in order to consolidate and pay off their high interest credit card debt. With average credit card interest rates hovering around 15% and P2P loans boasting interest rates as low as 7% for borrowers with excellent credit it could certainly be a wise move financially to use a P2P loan as part of your credit card debt elimination plan. Your credit card debt is probably going to be the most expensive debt you ever service. As such, if you are currently carrying outstanding credit card debt it just makes sense to come up with a plan to eliminate the debt whether you use a P2P loan or another method.

Additionally, P2P loans are installment accounts instead of revolving accounts (like your credit cards). When you carry outstanding debt on a revolving credit card account your credit scores will suffer even if you make every single payment on time. Credit scoring models don’t like high revolving utilization ratios, which is the relationship between your credit card balances and the limits on your open credit card accounts. However, since VantageScore and FICO do not consider installment debt the same way they consider your revolving debt you could absolutely see an increase in your credit scores simply by paying off your high interest revolving debt with a P2P installment loan.

The Downside

P2P loans are known for often requiring higher interest rates than those you would find in more traditional lending spheres. Many borrowers who take out P2P loans do so because they are unable to qualify for a loan elsewhere. Therefore in order to help offset the increased risk P2P lenders are taking on when lending to riskier borrowers it is common for these loans to cost the borrowers more in the long run when compared with traditional personal loans. In short, you may pay more for a P2P loan than you would pay for a loan of the same size at your local bank. But that’s a product of your risk and not a criticism of P2P loan options.

Will Peer to Peer Lending Help Build Credit?

Some P2P loans will also have the added benefit of helping you to build credit, assuming you make your payments on time, by reporting your monthly payment history to the credit reporting agencies. Unfortunately not all P2P lenders do this. If your goal is to use a P2P loan in order to help build positive credit history then be sure to check with the website ahead of time to see if they will report your monthly payment data to Equifax, Trans Union, and Experian. If they do not then you will not get any credit building benefit from the loan.