This year, Peer To Peer Lending has really gained momentum as a genuine finance alternative to the banks. With P2P, individuals and companies can raise funds directly from other individuals and organizations, side stepping the banks altogether.
In a post debt financial crisis world, traditional brick and mortar banks have tightened their lending requirements in a quest to reduce bad debts and improve the capitalization of their balance sheets. The problem is that many SME businesses and startups now find raising finance the traditional way all but impossible.
How Peer To Peer Lending Works – An entrepreneur needs £15,000 to set up a new business. Via the Peer To Peer Lending route, they would set up an account as a borrower with a UK P2P website such as Lending Circle. After due credit checks, the entrepreneur can create a profile which describes what the funds are needed for. Depending upon the perceived credit worthiness of the entrepreneur, the P2P company will attach a risk rating and assign an interest rate for the loan. In this way, the registered lenders (often cash rich individuals) can effectively lend the money and receive the interest rate. As you might expect, the interest rate is markedly higher than the prevailing risk free rate of return available in the market (ie bank savings accounts). However, it is usually quite competitive for the borrower. Once a number of lenders have agreed to lend their money to make up the £15,000, the loan becomes active – the cash is deposited in the account of the borrower, and regular interest rate payments are directly deposited to the lender. The entire logistics from credit checking to distribution of funds is handled by the P2P site.
Peer To Peer Lending Advantages & Shortcomings – The P2P lending concept truly offers far more positives than negatives. The main advantages are :
- Safety. Both lenders and borrowers are reasonably well protected. Once the borrower gets the funds, it’s theirs to do with as they need. On the flip side, investors can rest assured that every last penny of theirs will be lent to someone who has been credit checked and has passed a minimum safety level. Of course, that’s not to say a default on a loan cannot happen – it just moderates the risk.
- Huge growth. According to a study by Nesta, the UK P2P market could top £12 billion within the decade – banks currently lend about £70 billion to UK business. The industry is growing vapidly.
- Convenience. From the borrowers perspective, the entire loan approval process is carried out online. No visits to a bank manager or having to go through a grueling interview to get the loan. So long as your credit check comes back ok, you’re pretty much in.
However, here are a couple of shortcomings with the P2P model:
- P2P is not the right avenue for large loans. For those needing a few thousand pounds, P2P works great. If you needed a huge loan, P2P at this time would not be the right avenue for you.
- Default risk. For those looking to generate a return on their spare cash by being a P2P lender, there is still a risk attached that the borrower could default. While the default rate tends to be low, it’s important to spread your cash evenly over many different borrowers.