P2P Lending Explained: Business Models, Definitions & Statistics

October 17th, 2020
30 minutes read

Peer-to-Peer (P2P) lending can be described as a type of debt-based crowdfunding facilitated by online P2P lending platforms that connect borrowers and lenders by circumventing conventional loan processes, requirements, and intermediaries. The peer-to-peer lending market is showing impressive growth rates all over the world and provides much-needed finance to both startups and more established businesses.

For investors, peer-to-peer lending offers the opportunity to receive stable returns in the form of frequent interest payments, why it can be a great supplement to more traditional asset classes like bonds and stocks. So far, P2P lending is still viewed as an alternative investment but with low interest rates on savings accounts as far as the eye can see, it is likely to develop into an essential part of a diversified investment portfolio.

What is Peer-to-Peer (P2P) Lending?

P2P lending enables individuals and companies to lend and borrow money by connecting lenders with borrowers directly through an online peer-to-peer lending platform instead of using a traditional bank as an intermediary. From an investor perspective, it is, however, also possible to invest on platforms that collaborates with loan originators, which blurs the direct relationship between lender and borrower (more on these platforms in the section “P2P Lending Business Model 2: Peer-to-Peer Lending with Loan Originators”).

Because P2P loans are split up in minor parts, it is possible for many different agents to finance them. Thus, the reason why peer-to-peer lending is often categorised as alternative finance is that it is a method to finance debt outside the traditional banking system.

Since the invention of money individuals and institutions (lenders) with money have been lending to people and businesses in need of money (borrowers). Peer-to-peer lending represents a convergence between collective financing and informal funding (also known as insider funding), which is financing achieved by mobilising existing social relationships like friends, family, or professional acquaintances. These are both financing methods with a long history, and a famous early example of collective financing is the Statue of Liberty’s pedestal that was partly funded using an open call to the public.

The explosive growth of the internet and social networks has significantly boosted the scope and potentials of P2P lending by enabling peer-to-peer lending platforms to establish online marketplaces that act as intermediaries between lenders and borrowers. This means that borrowers and lenders do not need to have existing social relationships with each other to make a transaction happen. Instead, the transaction is based on the credit information of the borrowers and the underlying assets (if any) backing the loan.

Lenders in P2P lending can be both private individuals and institutional investors, and traditional credit institutions such as banks are increasingly allowed by platforms to participate in the funding. The reward received by investors in peer-to-peer lending is interest payments that depend on the borrower’s risk of default and the term of the loan.

Borrowers in P2P lending can be both businesses and private individuals. While everyone who fulfils objective criteria like nationality, legal age, etc. can normally invest in P2P loans, borrowers must pass a credit rating system that defines whether it is possible to borrow and on what terms. Because borrowers achieve financing through an open call and it is easy for everyone interested to participate, investors/lenders are also contributing to the assessment of borrowers by choosing whether they want to participate in a loan or not.

Peer-to-Peer Lending Definition

P2P lending is also known as crowdlending or marketplace lending, but these terms all refer to the same phenomenon. What term is preferred is largely based on regional differences. Marketplace lending is being slightly more used in the Americas region compared to other regions, while crowdlending is almost exclusively a European term. However, in a worldwide perspective, peer-to-peer lending has in recent years developed into the most established term. In regulatory and academic reports, you may also encounter the broader terms `lending-based crowdfunding´ or `debt-based crowdfunding´ that usually cover both peer-to-peer lending and a few other business models like balance sheet lending and mini-bonds. You can get an overview of all debt-based crowdfunding models in our Crowdfunding Essentials Guide.

P2P lending is constantly developing, which is – in combination with the linguistic confusion described above – making it difficult to coin a precise definition of the phenomenon. Hence, an established, unifying definition is still lacking. Our suggestion is, therefore, to use a definition that establishes clear boundaries that separate peer-to-peer lending from traditional banking, but still leaves room for new business models like e.g. crypto lending. Following this logic, a draft for a simple and precise definition of P2P lending could be as follows:

Peer-to-Peer (P2P) lending is a crowdfunding type that allows individuals and institutional investors to provide debt financing to a consumer (natural person) or business borrower (legal entity) in the form of a loan agreement that includes the obligation to repay the loan amount including interest (if any).

Peer-to-Peer Lending Platforms

P2P lending platforms enable interactions between the demand side (borrowers) and supply side (lenders) of the funding process. To create a well-functioning marketplace, the two most essential jobs for platforms are to recruit borrowers and lenders and to set the rules and terms of engagement. Besides market-making, key functions also include loan processing and activities contributing to building a community. 

The main sources of income for platforms in peer-to-peer lending are origination fees charged to the borrower, repayment fees charged to the lender, and/or other fees like loan part trading fees and late fees. How a peer-to-peer lending platform earns revenue depends largely on the business model of the platform and how the investment is structured, which will also have a great impact on the risk structure faced by investors.

Platforms in P2P lending generally operate with lower operating costs compared to conventional credit institutions, which enables them to offer attractive conditions for both lenders and borrowers by transferring these lower costs across both the supply and demand side (or so is the claim). Thus, in the best-case scenario lenders are offered attractive returns compared to other savings and investment products and borrowers are offered access to capital, competitive interest rates, and a swifter process compared to similar products offered by banks. In addition, according to Cummins et al., lenders are attracted by risk diversification, lower transaction costs, and access to market, while borrowers are attracted by transparency and – in some cases – the promise of non-collateralised loans.

There are several ways of categorising peer-to-peer lending platforms, which is something you should be aware of when you try to find the right platform for you. The most used way to categorise platforms is by borrower type, business model, and/or loan use:

  • Business model: Standard P2P Lending (e.g. October), P2P Lending with Loan Originators (e.g. Mintos), Bank-funded P2P Lending or Balance Sheet Lending
  • Borrower type: P2P Consumer Lending – a natural person (e.g. Bondora) – or P2P Business Lending – a legal entity (e.g. Crowdestor).
  • Loan use: Real estate/property (e.g. EstateGuru), education (e.g. Lendwise), social impact (e.g. Lendahand), payday consumption (e.g. Twino), invoice financing, agriculture, car purchase, etc.
  • Collateral: Real estate, business, invoice, car, etc.

Besides, technological developments can sometimes pave the road for new categorisations and business models, like for example crypto lending aka blockchain-based P2P lending.

If you are on the lookout for specific platforms that fit your investment preferences you can read our platform reviews that includes platforms from a variety of the categorisations listed above. If you already know you have a certain preference regarding, for example, collateral or business model you might also be interested in our collection of the best platforms within specific categories and regions, like the best real estate crowdfunding platforms in Europe.

Peer-to-Peer Lending Business Models

When you invest in peer-to-peer lending, it is particularly important to understand the business model of the platform where you invest as this has a major impact on the risk faced by investors. The same applies if you are a borrower looking to raise funds for your business or some other purpose. Currently, four general business models exist in peer-to-peer lending: 1. Standard P2P Lending, 2. P2P Lending with Loan Originators, 3. Bank-funded P2P Lending, and 4. Balance Sheet Lending.

In standard peer-to-peer lending (business model 1) there is only one middleman (the platform) between you and the investor, which makes both the business model and the incentive of the platform fairly easy to understand. In P2P lending with loan originators (business model 2), there are two independent parties between you and the borrower (the platform and the loan originator), which makes it harder for investors to understand the incentive of the platform and who is borrowing at the platform. The last two business models are closer to shadow banking and it is up for discussion whether these should be included as peer-to-peer lending. We have, however, chosen to include both bank-funded P2P lending and balance sheet lending in this review to give you a complete idea about the business models you might encounter as an investor interested in P2P lending.   

Below, we will explore these business models and highlight the pros and cons of each.

P2P Lending Business Model 1: Standard P2P Lending

The standard understanding of peer-to-peer lending is that you lend or borrow money to/from your peer with a middleman, the peer-to-peer lending platform, to mediate the transaction. This makes the standard P2P business model pretty straightforward:

  • Lenders (private individuals and/or institutional investors) invest excessive cash flow in loans on the platform and receives principal and interest in return.
  • The borrower (a consumer or business) receives financing and pays interest on the loan amount in return.
  • The platform is handling administration and attracts both borrowers and investors.

An illustration of the standard P2P lending business model can be found below. To emphasize the different actors in the funding process, the supply-side (lenders/investors) is highlighted in blue and the demand-side (borrowers) is highlighted in red. In the middle, the P2P lending platform’s role as an intermediator between the demand- and supply-side is illustrated:

Infographic of traditional peer-to-peer lending business model

In return for a fee, the platform handles administration and the loan contract, takes care of missed payments, makes sure borrowers pay on time, deals with bad payers and sorts out the legal issues of retrieving as much of the loan as possible in the case of a bankruptcy or loan default.

Thus, the peer-to-peer lending platform is administrating the financing business between the lenders and the borrower and takes care of attracting both borrowers and investors. If investors leave the platform because of bad returns, there is nobody to supply funding to the borrowers – and the platform will eventually go out of business. If the borrowers leave the platform because of bad treatment and bad terms, there is nobody to provide investors with a return – and the platform will eventually go out of business.

In standard peer-to-peer business lending, the risk of investors is placed at the borrower. This means that if the borrower does not pay back the borrowed amount the investor might lose capital. Consequently, a platform that uses the standard P2P lending business model is dependent on its market position and on having a reputation as a fair and profitable marketplace for facilitating loans.

P2P Lending Business Model 2: P2P Lending with Loan Originators

Compared to standard peer-to-peer lending, the second business model involves an extra layer, a loan originator, which makes the loan process a bit less intuitive to understand for investors.

A loan originator is a non-bank financial institution that uses marketing to acquire borrowers looking for a loan. The two main jobs of loan originators are to convince borrowers that their lending terms are attractive and to help borrowers navigate the closing table. However, for both investors and borrowers, it is important to keep in mind that a loan originator is a sales entity first and a loan approval adviser second.

Loan originators have traditionally been focused on mortgage loans, but many have seen a potential in the peer-to-peer lending market. Here, loan originators can find financing for their loans by making agreements with peer-to-peer lending platforms that their loans can be facilitated on the platform’s marketplace. At the same time, this provides platforms with a steady flow of loans for their lenders to invest in.   

The use of loan originators in P2P lending started in 2009 when Twino as the first peer-to-peer lending platform started using loan originators as a key element of their business model. Since then many platforms have followed and some of the largest and most famous P2P lending platforms today are operating using this business model with a prominent example being Europe’s largest P2P lending platform Mintos.

P2P Lending Business model 2 is illustrated below – again with the supply side in blue and the demand side in red. In this illustration, we have added the loan originator as a provider of loans to the platform:

Infographic of new Peer to Peer lending business model with 3rd party loan originators

In this business model, loan originators take care of the demand-side by providing loans to the platform, which enables platforms to focus their marketing only on attracting lenders/investors (the supply-side). Thus, the main difference between business model 1 and business model 2 is that the loans available for investing in business model 2 is originated outside of the platform. This allows the platform to facilitate larger loan volumes faster and provide a more stable short-term cashflow compared to platforms using the standard P2P lending business model. However, it also makes the loan process and risk structure less transparent to investors.

Since the loan originator’s loans are facilitated on the platform’s marketplace, it is possible for the platform to remove the loan originator if it provides bad returns and instead try to find someone more reliant. This could happen if, for example, the borrowers provided by the loan originator to the platform repeatedly do not pay back their loans. This will lead to investors losing money, which will force the platform to react because it must make sure investors see good returns to keep them on the platform.

Buyback Guarantees and Other Insurance Products

To convince investors they will not lose their money, P2P lending platforms that use business model 2 often structure the investments to include a buyback guarantee or another insurance-like product. This sort of “guarantee” is a deal, which gives investors a promise from the loan originator that it will buy back bad loans after a given period, usually between 30-90 days of delinquency – if they have enough money in their company to do it.

At first glance, this might seem safer than standard P2P lending, but in the end, the one that pays your return as an investor is the one borrowing the money. It is therefore important to remember that the ultimate risk of losing capital for investors in peer-to-peer lending is when borrowers do not pay back the money they have lent (at least if you know how to avoid investing in a peer-to-peer lending scam). Compared to the standard P2P lending business model, peer-to-peer lending with loan originators moves the risk to the loan originator company that in the end has its risk at the borrowers. The incentives for the peer-to-peer lending platform to make sure the loans on their platform is worthy of investment might, therefore, be weaker than in standard P2P lending. However, there are also benefits of using platforms operating with loans covered by a buyback guarantee, such as better predictability of the cashflow and interest earned from your portfolio of loans.

If you interested in learning more about this subject, make sure to check out our list of buyback guarantees and provision funds in peer-to-peer lending.

Pros & Cons: Standard P2P Lending vs. P2P Lending with Loan Originators

Pros/ConsTraditional P2P Lending business modelP2P Lending business model with Loan Originators
  • Higher quality of loans
  • High transparency
  • Simple and straightforward
  • Always direct investment structure
  • High volume of loans
  • More stable short-term cashflow
  • Borrower debt collection is quick (as a lender with buyback guarantee)
  • Low volume of available lows
  • Debt collection takes the time it takes (in extreme cases it might take years)
  • Cashflow is more inconsistent (a borrower default impacts total repayment right away)
  • Lower quality of loans
  • Less transparent
  • More complex risk structure
  • Mix of indirect & direct investment structure
  • Possibility of losing everything in the case of loan originator bankruptcy

P2P Lending Business Model 3: Bank-funded P2P Lending

In addition to standard P2P lending and P2P lending with loan originators two other business models will sometimes be counted as peer-to-peer lending: bank-funded P2P lending and balance sheet lending. These business models are, however, closer to traditional bank lending than business model 1 and 2 and they are, therefore, also at times regarded as shadow banking. More on this in the next section.

Bank-funded P2P lending resembles standard P2P lending in that the platform matches borrowers and lenders. However, instead of transferring money from the lenders to the borrower after loan origination, the loan is originated by a bank, which means that the borrower will sign a promissory note with the loan terms to the bank. Immediately after the bank has originated the loan, it will then sell it to the peer-to-peer platform that buys it with money raised from the lenders. Since the platform now owns the loan, the borrower will make repayments to the platform, which will transfer these on to the lenders. In this situation, both the platform and the bank become intermediaries without credit risk, meaning that the platform has no obligation to compensate investors in the case of losses.

P2P Lending Business Model 4: Balance Sheet Lending

Balance sheet lending is the business model in the peer-to-peer lending sphere that bear the closest resemblance to traditional bank lending. In traditional bank lending, funds are listed as liabilities and loans are listed as assets on the balance sheet of the bank. This means that banks take on credit risk, while customers’ deposits are usually insured up to a certain amount. In the same way, platforms involved with balance sheet lending will both originate the loan and keep it on the balance sheet. By doing this, the platform assumes credit risk, but it will also profit from both fees and interest payments accruing on the loan. Just like other types of peer-to-peer lending, balance sheet lending can be both consumer and business lending.

Is Peer-to-Peer Lending Shadow Banking?

A shadow bank is a financial intermediary that provides credit services comparable to that of traditional banks but without being subject to the same banking regulations or only loosely linked to these.  

Both banks and peer-to-peer lending platforms are connecting people with excessive capital and borrowers. However, there are two great differences between traditional bank lending and peer-to-peer lending. These differences also reveal that some types of P2P lending are very close to shadow banking, while others belong to a category we have chosen to coin as standard P2P lending.

So, what is the difference between traditional bank lending and peer-to-peer lending? First of all, when you deposit money in a traditional bank, you hardly have any visibility regarding how the money is used, whereas lenders on standard peer-to-peer lending platforms are free to choose the projects, businesses or consumers they want to lend money. Second, standard peer-to-peer lending platforms remove the need for balance sheet intermediation, which means that the lenders – and not the platform – are exposed to credit and liquidity risk.

According to the OECD, standard peer-to-peer lending platforms cannot be considered shadow banks because lenders bear all risks, which means that funding does not have deposit-like characteristics and platforms do not perform risk transformation. Also, standard P2P lending platforms do not use direct or indirect leverage, nor will they be prone to self-fulfilling bank runs by guaranteeing maturity transformation and/or liquidity transformation.

Given the description of the different business models within the peer-to-peer lending universe, it is, therefore, important to keep an eye on hybrid business models that might express some of these characteristics. This could be both peer-to-peer lending with loan originators (business model 2), bank-funded P2P lending (business model 3) and balance sheet lending (business model 4). However, especially platforms using balance sheet lending have a business model similar to banks as they rely on leverage and retain credit risk by keeping the loans on their balance sheet

The Market of P2P Lending: Statistics and Developments

The global P2P lending market has shown extraordinary growth rates since 2013, where systematic data collection in all regions of the world began. Below we will present data collected by the Cambridge Center for Alternative Finance (CCAF) that we have processed to highlight the development of peer-to-peer lending both worldwide and regionally. Because the CCAF collects their data using surveys there is a time lack in the collection and publication of data. This means that even though the last report was published in April 2020, the latest available data is from 2018.

If you are looking for more detailed, platform-specific data, we provide monthly updated data on funding volumes from the peer-to-peer lending and equity-crowdfunding market in both EUR, GBP, USD, DKK, and CHF.

Regional Distribution of Global P2P Lending Funding Volumes

Let’s start by comparing the data from 2017 with the new data from 2018.

In 2017, the global peer-to-peer lending market funded loans for $356.12 billion, but an important observation is that this loan volume was very much concentrated on a few large countries/regions. According to the data from the Cambridge Center for Alternative Financing, P2P lending is absolutely dominated by China with a market share of 92.1% of the global market. Below is a depiction of each region’s market share of the global P2P lending volume in 2017, which shows that China is followed by the United States with a market share of 5.0%, then the United Kingdom with a market share of 1.7%, and lastly Europe (excluding the UK) and the Asia-Pacific region (excluding China) both with a 0.6% market share.

Graph of regional p2p lending market share in 2017

The respective numbers of each region in 2017 was as follows:

  • China: $327.80 billion
  • The Americas: $17.71 billion
  • The United Kingdom: $6.01 billion
  • Europe (excluding the UK): $2.18 billion
  • The Asia-Pacific (excluding China): $2.12 billion

We have previously written about how the Chinese P2P lending industry has experienced massive turmoil in recent years – and since then additional frauds and scandals have surfaced. Lately, regulators have intensified their crackdown on Chinese P2P platforms making the future of P2P lending in China even more uncertain.  It is therefore important to keep in mind that the numbers from China are especially prone to misrepresentations. 

The regional distribution of funding volumes from 2018 also reflects the uncertainty of China’s peer-to-peer lending market by showing a huge drop in the Chinese funding volume of -37%, going from $327.8 million in 2017 to $207.9 million in 2018. This decreases China’s global market share to 82.7% and even though all other regions increase their overall funding volume the total market drops to by -29%, from $356.1 million in 2017 to $251.3 million in 2018 – the first-ever registered decrease in the total yearly funding volume.

The Americas region (again, primarily the US) gains a large part of global in 2018 compared to 2017 and now has a market share of 11.5%. Next on the list is the UK with a market share of 2.5%, followed by Europe (excluding the UK) and lastly the Asia-Pacific region (excluding China) with 1.4%.

The respective numbers of each region in 2018 was as follows:

  • China: $207.89 billion
  • The Americas: $17.71 billion
  • The United Kingdom: $6.36 billion
  • Europe (excluding the UK): $4.03 billion
  • The Asia-Pacific (excluding China): $3.41 billion
Graph of regional p2p lending market share in 2018

Even after the massive drop in 2018, China maintains its dominant position globally with a market share of 82.7%.  Because of China’s leverage and the uncertainty regarding the validity of the Chinese data, it makes sense to investigate how the global P2P lending market is distributed if we remove China from the data set. To provide you with an idea of how the regional distribution would look like in that case, below you will find similar pie charts for 2017 and 2018 as the ones presented above but with China excluded from the data:

Graph of regional p2p lending market share in 2017 exclusive China
Graph of regional p2p lending market share in 2018 exclusive China

Historical Developments in Global P2P Lending Funding Volumes

Looking at the global peer-to-peer lending market volume we find a market that experienced its first every year-on-year decrease after having developed rapidly since 2013. However, as explained above, the data set is skewed by the large weight of China, which means that even though the total global market dropped in 2018, all other regions continued their growth. It is again important to keep in mind that insecurities in the numbers used can have a great impact on the actual market size. However, the numbers presented here are the best estimate we have.

Data collection by the CCAF started in 2011 in the UK, and in 2012 the European market was included as well. In 2013, all regions of the world were covered for the first time. To have the best possible basis for making predictions for the global peer-to-peer lending market and compare regional differences, we will, therefore, begin our data series with the numbers from 2013.

Below, you will find the figure “Global P2P Lending Market 2013-2018 in billion USD ($)” that will give you an overview of both the regional development and the overall market size in terms of funding volume.

Graph of the global p2p lending market size growth from 2013-2018

Except for 2018, the numbers show impressive yearly growth rates that nevertheless follow a pattern similar to many young markets, where we often see a slowdown in growth rate as the volume goes up:

  • 2013: Loan volume: $9.73bn
  • 2014: Loan volume: $35.63bn – Growth rate: 266%
  • 2015: Loan volume: $124.33bn – Growth rate: 249%
  • 2016: Loan volume: $232.72bn – Growth rate: 87%
  • 2017: Loan volume: $356.14bn – Growth rate: 53%
  • 2018: Loan volume: $251.35bn – Growth rate: -29%

As can be seen from the numbers above, the year-on-year growth has increased every year from 2014, culminating in 2018 with a decrease in growth of -29%. This decrease in growth should, however, mostly cause worry for the future of the Chinese market and not peer-to-peer lending as a global phenomenon. If we again investigate the market development by excluding China from the data set, we see a somewhat different trend:

Graph of the global p2p lending market size growth from 2013-2018 exclusive China

In the figure above, instead of a drop of -29% in 2018, we see an increase in the yearly growth rate of 53%, which comes after the global market without China experienced a drop of -9% in 2017. The data for the global peer-to-peer lending market without China can be found below:

  • 2013: Loan volume: $4.21bn
  • 2014: Loan volume: $11.45bn – Growth rate: 172%
  • 2015: Loan volume: $26.75bn – Growth rate: 134%
  • 2016: Loan volume: $31.01bn – Growth rate: 16%
  • 2017: Loan volume: $28.34bn – Growth rate: -9%
  • 2018: Loan volume: $43.46bn – Growth rate: 53%

The future of P2P lending will be interesting to follow in the years to come – and our best guess is that we will see continued growth in the coming years in all regions except China that still has some cleaning up to do before the market can be expected to stabilise. Thus, lower funding volumes from China as a consequence of stricter regulation on Chinese P2P lending platforms might continue to affect to total global market negatively. However, with an increased focus on regulation and cross-border transactions, great untapped potential in many countries and regions, and a generally increased fascination with DeFi (decentralised finance) the future of peer-to-peer lending still looks bright.

The data presented on peer-to-peer lending in this section has been found by compiling regional funding volumes from P2P consumer lending, P2P business lending, and P2P property lending

Explanations and Potentials for Growth in P2P Lending

In 2015, the first peer-to-peer lending platform, Zopa, was launched in the UK. As can be seen from the section above, the peer-to-peer lending market has grown substantially since then. From a theoretical perspective, this growth can, according to Serrano-Cinca, Gutierrez-Nieto & López-Palacios (2015), been explained through the market equilibrium theory and the financial intermediation hypothesis.

The market equilibrium theory states that efficient markets are characterised by a state of equilibrium between supply and demand. Thus, advocates of the market equilibrium theory claim that peer-to-peer lending platforms bring the credit market towards equilibrium by solving a credit rationing problem that exists because there are borrowers, especially in economic downturns, who do not receive loans even if they are willing to pay higher interest rates. On the other hand, the financial intermediation hypothesis focuses on the fact that peer-to-peer lending platforms are more cost-efficient and have lower intermediation cost than banks, which makes them more attractive to both borrowers and lenders as competition forces platforms to share these lower cost with both sides.

From a more practical perspective, a research report on financial technologies from the International Organizations of Securities Commissions (IOSCO) pinpoints four supply and demand factors that have supported the growth of peer-to-peer lending:

  1. Reduced technology costs
  2. Underserved market segments
  3. Low interest rates
  4. Risk diversification

Below we will briefly elaborate on each of the highlighted factors.

Reduced Technology Costs

The operating costs of peer-to-peer lending platforms are minimised because of the online nature of all business models, which reduces the cost of attracting both borrowers and lenders. At the same time, algorithms can be utilised to automate processes like credit scoring and diversification of investments by lenders. Lastly, because peer-to-peer lending platforms normally do not participate in lending decisions or collect deposits as in traditional bank lending, their intermediation and transaction costs are kept low.

Underserved Market Segments

In many countries, the demand for capital is lower than the available supply of capital because startups and SMEs (small and medium-sized enterprises) are underserved by traditional banks. This is especially true in China where the large public banks have mostly played the role of serving large corporations. For small scale investors, peer-to-peer lending can at the same time be an attractive place to invest even minor sums.

Low Interest Rates

Low interest rates (in periods even negative) have been the norm since the global financial crisis of 2007-2008. The same is true for yields on sovereign bonds, which has forced investors to look elsewhere in the search for higher yields. Here, P2P lending represents an alternative investment that offers potentially higher returns. However, as is always true with investments offering high returns, investors must also be willing to accept a higher risk.  

Risk Diversification

Peer-to-peer lending offers individual investors the possibility to invest in loans – something that was previously mainly possible for institutional investors. In continuation of the low interest rates described above, this provides a welcome opportunity to introduce a higher degree of risk diversification in the individual investor’s portfolio.

How Does Peer-to-Peer Lending Work?

In this section, you will find a thorough step-by-step guide to the peer-to-peer lending process. The figure below illustrates every step – from picking out a loan (if you are an investor) or making a loan application (if you are a borrower) to the final payment.

Please note that the guidelines provided are general guidelines that primarily apply to standard peer-to-peer lending (business model 1).

Infographic on how peer to peer lending works - dynamics between the lenders, the platform, and the borrowers

Step 0: Loan Picking and Loan Application

Before the actual lending process begins, potential borrowers make an application for the desired loan on the platform. Depending on the platform, this application must contain certain information and data enabling the platform to assess the borrowing capacity and creditworthiness of the borrower. In some cases, the platform can choose to outsource this process to a rating agency or loan originator that then reviews and denies/accepts the loan takers on behalf of the platform. If the borrower is a private individual this is commonly referred to as peer-to-peer consumer/personal lending, while a company borrowing from the crowd will fall into the category of peer-to-peer business lending.

Now, if you find yourself in the blue circle and have money you want to invest in peer-to-peer lending, you start by picking out loans that you find attractive based on your risk profile. In addition to picking a stable and trustworthy P2P lending platform for your investments this is, of course, the most important part on your way to success in the world of P2P loan investing.

Step 1: Negotiating the Loan Agreement

In the processes of due diligence and reviewing the loan applicant, the platform will estimate whether the specific loan is appropriate for them to place on their marketplace. This is essential for investors to maintain trust in the platform to do a proper job of finding borrowers able to pay back loans – and in end provide a return for investors. 

No matter if the risk is categorised as C- or A+, the crucial part is that the borrower has a high probability of paying back the loan. When the platform has accepted an applicant and placed it on their platform for potential funding, it is up to investors to decide whether the risk commensurate the potential reward. If enough investors offer to finance a specific loan, the process is yet again validated by the platform to ensure the legality of assuring the money gets to the right person/company and that the repayments are structured. This completes the loan agreement. 

In the end, it is the goal of the investor/lender as well as the platform to facilitate loan agreements that returns both principal and interest to the lender.

Step 2: Transferring the Loan Principal

Once the platform has done their due diligence and accepted the borrower to their platform, the loan terms are structured and agreed upon between the borrower and the platform. When and if the terms of the loan are acceptable to the platform, the platform will determine a time frame for funding the amount asked for by the borrower. The platform will then release the project making it available for lenders to invest a minimum amount that varies from platform to platform. 

The P2P lending campaign is now available to the public. Whenever a lender invests an amount of money in the project, this sum is locked and in escrow with the platform. If a company wants to borrow e.g. $1,000,000 from the crowd, it will typically only be completed if the total amount of $1,000,000 is met within the time frame specified to fund the money. When this happens, the borrower has successfully completed the crowdfunding campaign and the investors will no longer be able to cancel their commitment of lending the money. The platform will then collect the promised amount from the different investors and have the borrower sign the agreement. The process is then ready to be finally settled and the loan principal can be transferred to the borrower.

Step 3: Receiving the Loan Principal (minus any platform fees)

When the loan amount has been transferred from the lenders to the platform, the platform will transfer it to the borrower. This transaction settles the loan agreement and the amount transferred is now owed to the lenders and is to be paid back according to the terms agreed upon in the loan contract – for example time frame (duration), interest rate, type of loan, securities, and rules on how to act if the borrower misses payments or do not pay back the loan on the terms agreed in the contract.

Step 4: Repayment of Principal and Interests (including any platform fees)

When the loan amount has been received by the borrower and the agreement is settled, the received amount becomes the principal, which is the total amount owed to the investors. The amount that needs to be paid back to the investors/lenders is composed of two components: The interest and the instalment/principal payments. 

The instalments reduce the amount due according to the loan contract and are usually paid evenly in instalments monthly (amortizing loan), quarterly (serial loan) or the total amount at the end of the loan (interest-only loan). This is specified by the type and duration of the loan. 

The interest is usually paid at the same time as the principal payments and consists of the costs for borrowing the money. The peer-to-peer lending platform is keeping track of the payments specified in the loan agreement between the borrower and lender. The platform’s earnings/fees for facilitating the payments are usually tied to the interest. This creates a healthy incentive for the platform to secure the payment of interest to the lenders and makes sure that the platform does not only focus on facilitating as many loans as possible but also on fulfilling the loan to the last payment. 

An example of this could be a platform fee of 1% on the remaining amount owed to the lender. This means that if the interest rate is, for example, 8.95% the lenders will receive 7.95% upon each received payment along with the instalment that pays down the loan. For the investors/lenders this means that when the principal is transferred to their account at the platform, the amount received is minus any platform fees. 

Below you will see an example of interest payments and instalments on a loan of a million dollars, with interests of 6.95% and a duration of 24 months paid back in annuities: 

Table displaying peer to peer loan repayment schedule

Step 5 –Fulfilling the Transaction and Receiving Payments

The last step in the process of peer-to-peer lending is the fulfilment of the transaction to investors who will receive the final instalments/payments. This means the transaction between lender and borrower has been successfully fulfilled with the lender receiving his or her payments according to the terms, which should make everybody satisfied.

This is the ideal scenario in peer-to-peer lending, but during the five (six) steps is also the possibility of bankruptcy. This is the risk a P2P investor must be willing to take to earn interest. If there were no risk, the investor would not be paid, and the interest hopefully reflects the risk associated with the loan subject for investing. In the traditional bond and stock markets, there is “no free lunch” – and the same should apply to P2P lending. High-risk loans with low or no security behind carry high interest (e.g. unsecured consumer loans with 12-18% interest and security of a single person), while low-risk loans with good security behind, carry low interest (e.g. a local authority like Vags Kommuna, a local municipality in the Faroe Islands, who took a loan with 0.45% interest and the security of their 1350 taxpayers – and in the end the government of Denmark).