Peer-to-peer lending (P2P) connects hopeful borrowers to lenders who are looking for a more profitable way to invest their money. Since lending restrictions have shut out many borrowing opportunities for prospective borrows, they have turned to P2P lending services to fund their small businesses, help them purchase a home, or fund anything that the borrower decides upon. Lenders who are not content with investing their money in stocks look to P2P lending as a way of increasing their rate of return. Understand how P2P lending works to decide if the rewards outweigh the risks for your financial situation.

Borrowers Are Evaluated by the Lending Firm

Potential borrowers must fill out the P2P lending firm’s application, where their circumstances are reviewed and rated according to risk. Borrowers must have an acceptable credit rating to join, but many of the banking restrictions do not apply. Borrowers may also qualify for a lower lending rate than they would otherwise get at a bank, so these crowd-lending platforms are very attractive.

Lenders Deposit Their Money with the Lending Firm

A lender sets up their account with the lending firm, and puts their money into it for a chosen amount of time. This investment is often “ring-fenced” – set apart from the lending company’s finances, as a safety measure should the company default. Since invested money is not guaranteed by the Financial Services Compensation Scheme (FSCS), some lending services have their own buffer accounts to additionally safeguard a lender’s investment.

The Invested Money Is Distributed to Borrowers

The lender’s money will be applied to any matching borrowers, but there is no guarantee that the money will be lent out immediately. The money does not earn the lender any interest during this time period, so there is an additional but slight financial risk here. Depending on the lending service chosen, the lender may be able to choose which borrowers they would prefer. With riskier borrowers comes greater interests, so if you do not mind a little risk, the reward could be well worth it. Lenders may also be able to set the terms and rate of interest as well.

Borrowers Repay Their Loans – Or Do Not

Borrowers must immediately start repaying their loans on a monthly basis. While there is no guarantee they will do so, lenders are protected by a provision fund that P2P lender services maintain. This fund allows lenders to be repaid even if their borrower is unable to do so. P2P lending services must also have insurance to cover the cost of a third party agency to collect outstanding debts in case their lending company fails, so you will be protected in that eventuality, even though it will likely take much longer to be repaid.

Lenders Collect Their Interest – As Does the Tax Man

All earnings from P2P lending services are subject to normal tax, which can make lending unattractive to some investors. However, depending on the lending company chosen, interest earned can be immediately reinvested and made available to new borrowers, effectively compounding your interest rate monthly. If a lender needs to withdraw all of the investment immediately, they will be subject to the P2P lending service’s penalty fees for early withdrawal, so make sure any investment can remain for the length of time indicated.

Use careful judgment before deciding to participate in P2P lending, either as a borrower or a lender. While the P2P lending industry became regulated in 2014, it is not without risks. Also keep in mind that P2P lending is still a fairly new enterprise, and there may be long term implications that have not came to light. Still, this lending model has helped thousands of borrowers fulfill their financial dreams, while simultaneously allowing lenders to make a tidy profit. Only you can decide if P2P lending is right for you.

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