What is Peer to Peer Lending? P2P Loans easily explained
Author
Reza Machdi-Ghazvini, CAIAThe abbreviation P2P stands for the English term "peer-to-peer", which can be translated as "private person to private person" or also as "person to person".
A peer-to-peer loan is a loan that is granted directly - without a bank or other financial institution brokering the loan. These loans have existed in the past and became much more common with the invention of the Internet.
In this article, you'll learn:
How do P2P loans work?
Unlike loans from banks, with P2P loans the banks take over the P2P platforms the mediation of loans.
For the mediation of the loans, they receive fees, which are typically borne by the borrowers.
With P2P loans, investors can achieve attractive interest rates in the double-digit range with calculable risks.
And borrowers also benefit from this form of credit, as they typically have to pay lower interest rates than with a bank loan and the bureaucratic effort (paperwork) is also much lower.
Furthermore, a peer-to-peer loan is a suitable alternative if banks are not willing to grant a loan.
By keeping banks out of the equation, everyone involved benefits.
Incidentally, P2P lending has been around since 2005: that was the year the world's first platform, Zopa, was founded in the UK.
However, compared to other traditional asset classes such as stocks and bonds, it is still a very young asset class.
If you want to invest in P2P loans or take out a P2P loan, you must at least register on a P2P platform.
Which P2P platforms are there?
Among the most established platforms in Europe are Mintos, PeerBerry and Twino. These platforms all have in common that they are headquartered in Eastern Europe.
In Germany, it is mainly the auxmoney* platform that is known.
But, on it, it is only possible for private individuals to take out loans. Investing is now reserved only for large institutional investors such as pension funds and insurance companies.
After successful registration, it is then possible to become active.
Either as an investor or as a borrower.
P2P loans for investors
To start investing on a platform, you must first deposit money.
To achieve this, you have to transfer the amount to your account at the platform via a standard transfer with a predefined purpose.
How this works in detail is described in detail by the platform.
After that, you have the option to automatically invest in the offered loans on all major platforms.
With the automatic investment function, which is usually called Auto Invest, you can then specify with a few settings in which loans you want to invest.
In most cases, the most important settings are already preset for you, and you can, but do not have to, make adjustments.
In very few exceptions, automatic investing is not possible, for example at tiny platforms.
Furthermore, it is usually possible to select each loan individually in which you want to invest.
However, this would be very time-consuming eventually and is therefore not recommended.
In the following, we will discuss the advantages, but also the risks from the perspective of an investor.
What are the advantages of P2P loans?
Attractive interest rates: The biggest advantage of peer-to-peer loans is that they offer double-digit interest rates. For comparison, the historical average return on stocks is around 5%.
Useful addition: During the past crises, P2P loans have proven to be a reliable asset class that did not experience high price losses. Therefore, P2P loans are a good complement to traditional asset classes such as stocks and bonds.
Transparency: With peer-to-peer loans, it is clear from the outset what is being invested in.
What risks can be expected when investing?
Default risk: The default risk means that a borrower can no longer meet his or her obligations. For investors, this means the partial or total loss of the investment amount that is tied up in this loan.
Platform risk (scam): Platform risk is a very specific risk of P2P loans. It describes the risk that you can suffer a total loss should a platform you are invested in become insolvent. However, this risk can be reduced to a large extent by investing only on established platforms.
Counterparty risk: Counterparty risk is only relevant for platforms that work with loan brokers (loan originators). It describes the risk of a credit intermediary becoming insolvent, with the consequence of delays and defaults on loans from that intermediary.
Foreign currency risk: For P2P loans in foreign currencies, the risk that arises from changes in foreign currency exchange rates must also be considered.
As you can see, there are some risks you have to pay attention to when investing, but otherwise you would not be able to explain the high-interest rates.
A successful strategy must therefore specifically counteract the known risks.
Diversification
Fortunately, the proven strategy for this is well known and easy to implement: You have to spread your capital over as many platforms and loans as possible.
In technical jargon, this is called a diversification strategy (spreading of investments).
P2P loans for borrowers
To take out a loan via a P2P platform, you must first provide some personal information after registering.
This includes basic information, such as the date of birth and also the place of residence, but also information about the monthly income and expenses.
The whole process corresponds to an online loan application for a loan and is self-explanatory.
Conclusion - P2P loans are an option for both investors and borrowers
P2P loans are an attractive way to invest money. Investors can sign up in a short time on one or more platforms to invest automatically.
For borrowers, the loans are a suitable alternative to a bank loan, especially if they have difficulty taking out a loan.
Would you like to learn more about P2P loans?
Then take a look at our P2P platform comparison to learn about the best platforms to invest on.