The traditional banking model has been in existence since the Bank of England began issuing banknotes in 1695. The old lending model is slowly beginning to crumble. It is being replaced by a relatively new concept known as peer-to-peer (P2P) lending or crowdlending. What is crowdlending and why is it gaining so much attention in financial circles these days? Let’s examine the details.
What exactly is Crowdlending?
In its basic format, P2P or crowdlending enables individuals or businesses to obtain loans directly from other peers through online services, matching lenders with borrowers. This type of format eliminates financial institutions as the middlemen. Essentially, P2P lending is an alternative method of financing.
Similarly, P2P lending allows investors (individuals or companies) to lend money to projects or persons at very interesting interest rates. By eliminating intermediaries (banks) and directly connecting lenders and borrowers, p2p lending enables the potential for better return rates for investors.
How does Peer-to-Peer Lending work?
P2P lending is a simple, straightforward process. In this section, we will give an overview on how p2p lending works for investors, not for the borrowers looking to get loans.
If you are new to P2P lending, you might be apprehensive about investing. Many first-time investors are under the impression that opening an account is a very complicated process. This is not true. In fact, opening a P2P account is very similar to opening a bank account. The process is very simple. There are three basic steps to investing with a peer-to-peer lender.
- Create an account in a P2P lending company by registering directly on the platform. In regard to collecting the necessary data, P2P lenders follow the same guidelines as a bank or brokerage firm. You will be asked to provide name, address, phone number, e-mail and photo ID.
- Transfer funds to the platform after the account has been created. The best way to deposit funds is via bank transfer, which typically takes 3 business days.
- Build you portfolio of loans. Arguably, the most difficult part of becoming a P2P investor is selecting a specific investment among all of the available projects on the platform. The majority of platforms offer several different options in terms of various maturity dates, level of risk, minimum investment, buyback guarantee, investment type, platform fees and ROI. The best way to select the appropriate investments is to do research and ask questions.
What are the Pros and Cons of investing through Peer-to-Peer Lending?
All investments have advantages and disadvantages, including P2P lending. Is P2P lending a good vehicle for potential investors? What about the borrower? Should the borrower use a crowdlending platform or seek financing through a traditional bank? The best way to answer these questions is to list the pros and cons of peer-to-peer lending.
- Higher returns to investors relative to other investment types. Nowadays, if you have your money in the bank, it’s most likely losing value, as inflation has beaten interest rates for deposits in Europe in recent years. Many bloggers have been documenting their P2P investments, and showing +20% annual returns on their investments – example here.
- Safety: Crowdlending platforms are meant to provide due diligence on the loans issued, and help investors protect their downside.
- Portfolio diversification opportunities: possibility to diversify your risk by chosing loans in different geographies, different types of loans, maturities, in different crowdfunding platforms, etc. It is also a way to diversify from your stock market investments – the first ever P2P platform didn’t suffer during the global financial crisis, returning 4% to its investors.
- Low barrier to entry: Minimum deposits are low, allowing anyone to start investing towards their goals.
- Loans defaulting: the majority of P2P loans are loans that weren’t accepted in banks, thus it is normal that some might fail, and that’s why return rates are high. As in any other investment, only invest money you are prepared to lose.
- Not diversifying: P2P lending is risky. But that risk can be minimized if you do the proper diversification.
- Crowdlending platforms may not be aligned with your interests: this can lead to bad investments. Make sure you do the proper research on the loans you are investing in, and make sure the interest rates offered are correct for the risk you will assume.
- Platforms collapsing: In 2015, Trustbuddy declared bankruptcy. Make sure you choose good platforms to invest in.
Peer-to-Peer Lending vs Crowdlending vs Crowdfunding
There seems to be some confusion between P2P (or Peer-to-Peer) lending, crowdlending and crowdfunding.
During the past few years, P2P lending is becoming more commonly referred to as crowdlending or marketplace lending. It’s basically the same thing. Each platform provides online financing by matching investors with borrowers.
Regarding crowdfunding and p2p lending, there are differences. First, let’s briefly discuss the main similarity between the two types of financing. P2P lending and crowdfunding share one common principal: both platforms provide online financing by matching investors with borrowers. This type of financing approach completely bypasses the legacy banking system.
The main difference between P2P lending and crowdfunding is how investors are repaid. P2P lenders receive interest payments from borrowers on a regularly scheduled basis. However, P2P lenders do not receive an equity stake in the borrower’s company. The borrower retains 100% ownership of the company. P2P loans are rather similar to a traditional bank loan. Based on the fact that P2P borrowers are required to make monthly interest payments, P2P loans are better suited for well established businesses. Typically, start-up businesses are cash poor. Consequently, they are unable to make monthly installment payments on a loan or line of credit (LOC). This explains why P2P loans are not a good fit for start-up or early stage businesses.
Crowdfunding is the preferred method for start-up businesses. In exchange for providing financing, lenders receive an equity ownership in the business. If you are an investor who prefers a steady income stream, crowdfunding would not be a good choice. In addition to equity-based crowdfunding, investors can also select rewards-based crowdfunding. In exchange for providing investment capital, the investor receives a finished product. For example, let’s assume that XYZ Music Company needs to obtain financing for manufacturing flutes. Several lenders provide financing. In exchange for much needed capital, XYZ Music Company gives each lender a flute. This is known as rewards-based crowdfunding.
- Peer-to-peer lending (P2P) is a method of debt financing.
- It allows individuals to borrow and lend money without the use of a financial intermediary.
- Essentially, P2P lending removes the middleman from the process.
- P2P lending is also known as crowdlending or marketplace lending.
- P2P loans are neither insured nor guaranteed.
- Uses small amounts of capital by individual investors to finance a new business.
- Allows the individual investors to obtain an equity ownership in the company.
- Investors and entrepreneurs are brought together through a crowdfunding website.
- Provides a forum for anyone wanting to “pitch” an idea to waiting investors.
- Start-up companies can raise money through crowdfunding without giving up control of the company.
P2P lending is certainly not designed for everyone. However, these loan programs continue to grow in popularity. Is P2P lending a good fit for you? Of course, only you can answer that question.
Once again, a reminder that the above should not be construed as investment advice and should be considered information only. Investors should do their own research and due diligence about the services and opportunities best suited for their risk, returns, and investment strategy.Peer-to-Peer Lending involves risks, including loss of capital.
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