What Is Peer To Peer Lending (P2P) and How Does It Work?

Also known as social lending and person to person lending, peer to peer lending is lending that takes place between individuals. Instead of having to go through the traditional route of borrowing money from a bank or even lending money to a bank in the form of deposits, people can log on to a peer to peer lending networks, such as Lending Club or Prosper and lend and borrow money from others who are also members of the network.
Thanks to the advent of the internet, people may find it a lot easier to borrow money for different uses. These websites that feature P2P lending allow regular people to assume the role of a banker and face the same risks as well as benefit from the same rewards. Many people who want to start a small business or maybe work from home on a part-time basis could not find a bank that would give them a loan. Of course their risk of failing was higher than a loan backed by collateral such as a car or house note. P2P lenders online lend money to people who are looking for alternative means of financing. Many peer to peer loans are used for small businesses looking to expand, consumers wanting to consolidate debt, students looking for educational loans, brides for their weddings, medical expenses, and a broad host of many other borrowing needs. The loan requests definitely run the entire gamut of financing.
How does this work? Borrowing money on a peer to peer lending service or website involves a borrower submitting a loan application on the website and lenders bidding to fund the loan. On some websites, the loan application includes the credit risk and other factors that could be considered by the lenders to search and bid on the loans if they choose the application. For example, Lending Club and Prosper, the two biggest P2P lenders, rate their loans on such factors as credit score, past delinquencies, income, housing situation, etc. Then when there are enough lenders online who are willing to loan the amount of money requested by the borrower (up to $25,000), the network then loans the borrower the money and sells portions of the loan to the lenders. So basically, the purpose of lenders is not to make the loans, but to buy a piece of the loan.
So, why lend money to a stranger? Because it pays well! I have written before about how I continually earn over 15% annually on the money I lend to borrowers through Lending Club. I also just recently began lending money on Prosper as well. There is a little more risk associated with some of these loans. After all, you are skipping the bank entirely. But, because of this risk that you assume, you are paid handsomely by a higher rate of return on your investment.

For those who are interested in becoming lenders, you can buy into a loan for as low as $25. Because of this it is easy to mitigate risk by diversifying your investment throughout many loans. I personally invest in two new loans per month for $25 each, and I have over 20 loans throughout both services.
Peer to peer lending makes lending and borrowing easier and provides a great investment opportunity for many investors. Like many types of investments, P2P lending should not make up a large percentage of your investment portfolio because of its increased risks when compared to investing in stocks and mutual funds which should make up a bulk of your retirement and investing portfolio. But, I have a lot of fun and feel a lot of satisfaction by helping out people directly with loans, and I currently have about 2% of my portfolio invested in peer to peer loans. It is a great investment tool to have in your arsenal, and I highly recommend it.