What is Crowdlending aka P2P Lending?

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Crowdlending or P2P lending is an asset class that needs to be taken seriously for every investor – and is unavoidable if you are into P2P investing. Either way, if you are looking for a solid source of passive income it is an excellent way of achieving frequent interest payments and boosting what Albert Einstein famously dubbed the most powerful force in the universe: Compound interest!

At the same time, comparing crowdlending/P2P lending to conventional investment assets available on the market today reveals that it is an essential part of a diversified and profitable portfolio [1]

1. The Many Names of Crowdlending

Crowdlending is known by many names, all referring to the same phenomenon. The first term established for brokering loans online was ‘Peer-to-Peer Lending’ or ‘P2P Lending’, but with the rising popularity of crowdfunding, the use of the term ‘Crowdlending’ has increased significantly. We will use these two terms interchangeably throughout this article, but as crowdlending is most commonly used this will be our primary go-to term. Also, ‘Marketplace Lending’, ‘Social Lending’ and ‘Business Lending’ is sometimes used to refer to the phenomenon of brokering loans online. Lastly, since crowdlending or P2P lending is a type of crowdfunding characterized by being loan-based, it is also known as ‘Loan-based Crowdfunding’ or ‘Lending-based Crowdfunding’.

2. The Definition of Crowdlending

Since the invention of money, people or institutions with money have been lending to people and businesses in need of money. The explosive growth of the internet and social networks has made it possible to bring this phenomenon online, thus enabling the possibility of borrowing directly to or from people you have never met based on the borrowers credit information. All happening through a trusted third party in the form of a crowdlending platform. Put simply, this is what is called crowdlending.

A more precise way to describe crowdlending is as a method of debt financing enabling individuals and companies to lend and borrow money through an online platform instead of making use of a traditional bank as intermediary. Here, the loans are split up in minor parts, which makes it possible for many different agents to finance the loan.

The lenders in crowdlending can be both private individuals and institutional investors. The reward received by the investors is interest payments that depends on the borrower’s risk of default and the term of the loan. 

The borrowers in crowdlending can be both companies and private individuals, and while everyone can become lenders on crowdlending platforms, borrowers usually must go through a credit rating system defining whether it is possible to borrow and on what terms. By making an open call and making it easy for everyone to participate in the financing, the lenders are contributing to the assessment of the loan by choosing whether they want to participate or not. Thus, in crowdlending, a is sometimes possible to draw on the so-called wisdom of the crowd.

Based on the facts described above, a simple way to define crowdlending or P2P lending is therefore as below:

Crowdlending/P2P lending definition 1:
“Crowdlending describes the process of brokering debt capital between lenders and borrowers of capital online.” [2]

Joint publication by PricewaterhouseCoopers, the Institute of Financial Services Zug IFZ at Lucerne University of Applied Sciences and Arts and the Swiss Marketplace Lending Association

A more elaborating definition is given by the European Banking Authority (EBA) who is defining crowdlending as: 

Crowdlending/P2P lending definition 2:
“Open calls to the wider public by fund seekers through a third party, typically an on-line platform, to raise funds for a project or for personal purposes, in the form of a loan agreement, with a promise to repay with (or in certain cases without) interest. The fund raisers may include individuals, start-up companies or existing SMEs that are seeking an alternative means of funding, rather than the traditional credit market.” [3]

The European Banking Authority (EBA)

What can be learned by EBA’s definition is that crowdlending, like other types of crowdfunding, involves three parties:

  • Providers of funding (private individuals or institutions)
  • An online platform mediating the transaction
  • Seekers of funding (private individuals or companies)

More on these below.

3. The Most Common Types of Crowdlending

An important distinction can be made between two overall categories of crowdlending: Company Crowdlending and Personal Crowdlending.

These categories are defined on the basis of the cash flow and assets behind the loan as these are accountable if the borrower (company or person) do not pay according to the terms. In terms of risk, it is therefore essential to keep in mind the distinction between the economics of an entity and the economics of a person. 

Under each of the categories, you will encounter many different types of crowdlending. We have summarized the most important ones in this figure of which a brief explanation can be found below: 

Company crowdlending involves an entity with it’s own cash flow and usually stronger assets to put as liability compared to personal lending, but cash flow with a life expectancy of a company (most new companies are not around after 7 years). Some of the most common types of crowdlending you will find in personal crowdlending are:

  • Business Crowdlending: Lending money to a business for working capital or expansion
  • Property Crowdlending: Lending money to a property for renting or development
  • Receivables Financing: Lending money to a business in exchange of receiving payment on an invoice
  • Agricultural Crowdlending: Lending money to agriculture, livestock or farm equipment

Personal crowdlending involves a person with his/her own cash flow and usually weaker assets to put as a liability, but cash flow with a life expectancy of a person. Some of the most common types of crowdlending you will find in company crowdlending are:

  • Consumer Crowdlending: Lending money with no securities that can be spend on anything
  • Car Crowdlening: Lending money to the purchase of a new or used car
  • Mortage Crowdlending: Lending money to the purchase of a home
  • Pawnbroking Crowdlending: Lending money to anything with the security of any given asset

4. The Two Business Models of Crowdlending

What is meant by peer-to-peer in crowdlending is not always straight forward as there is always at least a third party involved – the crowdlending platform facilitating the transaction. However, an other business model involving a fourth party, a loan originator, also exists. On what business model a crowdlending platform is based can have important implication for your risk as an investor. 

In the three party business model of crowdlending 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. The four party business model of crowdlending is a bit more complicated as there are two independent parties between you and the borrower. This means it can harder to comprehend the incentive of the platform and who is borrowing at the platform.

Below you will find an explanation of both business models.

4.1 The Three Party Business Model of Crowdlending

The basic understanding of peer-to-peer lending is that you lend or borrow money to/from your peer – with a middleman, the crowdlending platform, in-between. In return for a fee the platform will handle the administration and the contract, take care of missed payments and make sure the borrower pays on time, deal with bad payers and sort out the legal issues of getting as much back as possible in case of bankrupts.

The crowdlending platform is illustrated as a computer in the figure, the lenders in blue and the borrowers in red. The lenders, private individuals or institutions/companies, put excessive cash flow into the platform and gets back principal and interest in return. The borrower, a private individual or company, gets financing and in return pays back the amount plus an interest. 

The  crowdlending platform is administrating the financing business between the lender and the borrower. The platform then takes care of everything from attracting borrowers as well as attracting investors. If the investors leave the platform because of bad returns, there are nobody to apply financing to the borrowers – and the platform is gone. If the borrowers leave the platform because of bad treatment and terms, there are nobody to get a return from – and the platform is gone. A fair and easy model which is dependent on the reputation of the platform as a fair marketplace for facilitating loans and its position in the market. In this type of business model the investors risk is placed at the borrower – if the borrower do not pay back the borrowed amount the investor might loose capital. 

Examples: RendityEstateGuru, MonetheraEnvestio, Crowdestor and Crowdestate

4.2 The Four Party Business Model of Crowdlending

The second and more complicated peer-to-peer lending model, has one extra layer to its business model. The illustration is very similar to the more direct peer-to-peer lending model above, but between the crowdlending platform and the borrower is a loan originator.

A loan originator is the front door to the loan getting process. The loan originator has two jobs: The first is to persuade you that their lending terms are the best option for you. The second is to help you navigate to the closing table.

A loan originator is a sales entity first and a loan approval second. The loan originator has an agreement with a crowdlending platform, that their loans can be facilitated at their marketplace. This means that if the platform sees bad returns from the loan originator it can remove them from the platform and try to find someone more reliant (e.g. if the borrowers, the loan originator provides to the platform do not pay back the money and thereby making investors loose money, which the platform have to react to and show that it has consequences – the platform have to make sure the investors are seeing good returns).

This structure with an insurance/buy-back guarantee might seem more safe in regards of the platform not going bankrupt, but in the end as an investor the one that pays you a return, is the one borrowing the money. This lack of incentive in this type of crowdlending business model, is often insured by a financial insurance product called a Buy-Back Guarantee. This sort of “guarantee” is a deal, which gives the investors a promise from the originator, that if they have enough money in their company to buy back the loan if it turns bad, they will buy it back after for example 60 days of delinquency. In crowdlending, the ultimate risk of loosing capital for investors is when borrowers do not pay back the money lend. Compared to the more direct crowdlending business model, this type of model splits the risk to the loan originator company which in the end has its risk at the borrowers. The incentives for the platform to make sure the loans on their platform is worthy of investment might therefore be less than in the more direct peer to peer lending business model (the three party business model).

Examples: Mintos, Peerberry, Grupeer, Fast Invest, IUVO Group and Lenndy

5. The Process of Crowdlending Explained

5.1 Step 0 – Loan application and picking out loans

Before the actual crowdlending process begins, potential borrowers make an application for the desired loan on the crowdlending 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 reviews and denies/accepts the loan takers. If the borrower is a private individual this is commonly referred to as personal crowdlending, while a company borrowing through crowdlending will fall into the category of business crowdlending.

Now, if you find yourself in the blue circle and have money you want to invest in crowdlending, you start by picking out loans that you find attractive based on you risk profile. Besides picking a stable crowdlending platform for your investments this is, of course, the most important part on your way to success in the world of crowdlending. If you want to learn more about the risks involved in crowdlending, keep an eye on the site as we will soon be publishing an in-depth article on risks in crowdlending.

5.2 Step 1 – 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 for the investors that trust their company to do a proper job of finding borrowers able to pay back the loan. 

No matter if the risk is categorized as C- or A+, the essential 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 the platform for potential funding, it is up to the investors to decide whether the risk commensurate the potential reward. If enough investors validate and offer financing to a specific loan, the process is yet again validated by the platform and the loan agreement will be completed to validate the legality of assuring the money gets to the right person and the repayments are structured. 

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.

5.3 Step 2 – Loan amount transferred

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. They will then release the project and it becomes available for lenders to invest a minimum amount that varies from platform to platform. 

The crowdlending campaign is now available for the public. Whenever a lender invests an amount the money is locked and in escrow with at the platform. If a company wants to borrow 1.000.000 from the crowd, it will typically only be completed if the total amount of 1.000.000 is met by the lenders on the platform within the time frame specified to fund the money. When this happens the crowdlending campaign has then been a success in regards of the borrower, and the x number of investors will not be able to cancel the commitment of lending the money. The platform will then collect the amount from the different investors and get the borrower to sign the agreement. Thereby is the process ready to be finally settled and the amount to can be tranfered to the borrower.

5.4 Step 3 – Loan amount received (e.g. minus any platform fees)

When the loan amount has been transferred from the lender 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 lender and is to be paid back according to the terms agreed upon in the loan contract – e.g. 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.

5.5 Step 4 – Principal and Interest payments (including any platform fees)

When the loan amount has been received and the agreement is settled, this becomes the principal, which is the total amount owed to the investors. The repayment amount to the investors is composed of two components: The interest and the installment/principal payments. 

The installments reduces the amount due according to the loan contract and is usually paid evenly in installments monthly (amortizing loan), quarterly (serial loan) or the total amount in 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 crowdlending platform is keeping track of the payments specified in the loan agreement between the borrower and lender. The platforms 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 do 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 when the interest rate is 8,95 % you as a lender will receive 7,95% upon each received payment along with the installment that pays down the loan. For the investors/lenders this means that when the principal is transferred to their bank account at the platform, the amount received is minus any platform fees. 

Example of interest payments and installments on a small loan of a million dollars, with interests of 6,95%, a duration of 24 months paid back in annuities:

Small loan of a million dollars

5.6 Step 5 – Transaction fulfilled and payments received

The final step in the process of crowdlending is the fulfillment of the transaction and installments/payments are being received. This means the transaction between lender and borrower has been fulfilled and a success, the lender is receiving his or her payments according to the terms and everybody is satisfied. This is the ideal scenario in crowdlending, but in between the five steps is the possibility of bankruptcy. This is the risk the investor must be willing to take to be earning any interest. If there were no risk, the investor would not be paid and the interest hopefully reflects the risk associated with the loan invested in. In the traditional bond and stock markets there is “no free lunch” – and the same should apply to crowdlending. High risk loans with low or no security behind carry high interest (e.g. unsecured consumer loans with 12-18 % interest and security of the single person), while low risk loans with good security behind, carry low interest (e.g. local authority such as Vags Kommuna, a local municipality in the Faroe Islands, with 0,45 % interest and security of the 1350 tax payers and in the end the government of Denmark).

Sources

[1] Lustman, S. (2017). P2P Investing 101: Why the Smart Money Invests in Peer to Peer Loans.

[2]  PricewaterhouseCoopers, the Institute of Financial Services Zug IFZ at Lucerne University of Applied Sciences and Arts and the Swiss Marketplace Lending Association (2018). 2018 Crowdlending Survey

[3] The European Banking Authority (2015). Opinion of the European Banking Authority on lending-based Crowdfunding.

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