Peer-2-Peer Lending: The FundamentalsBy Written by Naeem Ghauri, Founder and Head of Global Sales on 29-11-2017
The continued low level interest rates in the US have created difficulties for investors. They have to either accept low yield or divert their capital to more risky alternative investment options such as real estate investment trusts, futures and options, and growth or dividend paying stocks. One alternative option that has caught the eye of investors is peer-to-peer (P2P) lending, which the federal US regulators classify as an investment option.
P2P lending provides an alternative investment opportunity to individuals that want to earn extra income on their capital. The investment option works out well for those investors in the US that take the time to understand the fundamentals as well as the rewards and risks. Here we will take a detailed look at the investment options to find out whether the benefits outweigh the risks from the perspective of the individual investors.
Peer-to-Peer Lending: Is it Real or Just a Fling?
P2P lending has blossomed into a mature financial market that according to the estimates of financial pundits stands at $4 trillion in the US . Although this pales in comparison to the $12 trillion issued in loans across the US, the market has grown 65 times since 2009 when a total of just $26 million were issued to individuals.
P2P lending, along with crowdfunding, is the fastest growing marketplace lending platform in the country. Unlike crowdfunding that is more geared towards financing new ideas and businesses, P2P lending is equipped more towards fulfilling the needs of the consumers. These include such things as consolidating existing debts, paying medical expenses, taking a holiday vacation, and other similar expenses.
The extent of the P2P lending market size today can be gauged from the 2015 earnings report of Prosper, which along with Lending Club is the biggest lending platform of its kind in the US. The company's 2015 financial report showed that the company originated a total of $3.7 billion - double the amount in loans originated the previous year - and made earnings of $81 million.
A number of factors can be cited for rapid growth of P2P lending. Modern P2P lending in the US started in February 2006 with the establishment of a Californian based firm, Prosper. This was followed soon after by Lending Club, after which many other lending platforms started offering this kind of loan.
Initially the concept of P2P lending was not such a big hit in the US. However, the tightening of lending policies by banks after the 2008 financial crises created an environment that made P2P lending the preferred option for many individuals. Consumer Protection Act and Dodd-Frank Act added further restrictions on availability of loans to the consumers. All of this contributed to the increase in demand of P2P lending as it allowed individuals to have easy access to much needed credit for meeting their financial obligations.
Notable P2P online lending platforms such as Prosper, Lending Club, Kabbage, OnDeck, and Funding Circle deal with loans that are required by individuals and small businesses. Kabbage, OnDeck, and Funding Circle focus on business loans ranging from $100,000 to $200,000 that are primarily used to pay for equipment, inventory, and franchises. Prosper and Lending Club firms on the other hand mainly deal with consumer loans which are typically of smaller amounts. Additionally, there are P2P lending firms that deal with other kinds of loans including student loans (Kiva, Sofi) and young borrower loans (Upstart).
How Does Peer-2-Peer Lending Work?
P2P lending in its most basic form is a type of investment option - not unlike crowdfunding - that brings borrowers and lenders together. The process connects borrowers with a group of lenders through an online lending platform. Due to the online nature of the operations, lending platforms incur relatively lower costs as compared to traditional loan companies. There are no costs of staffing and maintaining a large physical branch. These costs savings are passed on to the borrowers who do not have to pay hefty fees and charges that are incurred when obtaining loans from traditional banks.
P2P lending platform matches borrowers with prospective investors. It allows individual investors to participate in a pool of funds that are required to match investors with borrowers. Participating in pools of loan lessens the risk of investors as they can divide their capital over different loan amounts. They can use the credit score of the borrowers to determine the risk and their target profit level.
An individual who wants to borrow money submits an application with the online lending platform. The lending platform uses the information provided by the borrower to assign a risk grade, and also set corresponding interest rate. These rates are set based on the credit score of the applicant as well as other factors such as financial assets, income level, and past payment history.
In reality, different lending platform have different grading criterion. Lending Club, for instance, grade applicants from A to G. The following figure shows loan grading of the online P2P lending platform in 2016.
As can be seen in the figure, every loan grade is assigned an origination fee, interest rates as well as different period Annual Percentage Rate (APR). The APR reflects the costs of borrowing the money on an annual basis. It includes both the interest rate and origination fee charged by the lending company. Investors can review all the loan applications posted on the lending platform. They can assess risk-return potential of the loans through the grade of the loans, and select one that fulfills their desired investment requirements.
When there are enough investors that are ready to fund the loan, the loan is then originated by the bank that is known as the 'originating bank' whose deposits are insured by the FDIC in the US.
The originating bank sells notes, also known as 'borrower payment dependent notes', to the lending platform that in turn sells them to the individual lenders. These notes are registered by the Securities and Exchange Commission (SEC) and are guaranteed by the loans provided to the borrower. This means that the lenders can receive payment from the platform only when the borrower repays the loans amount.
Borrowers do not normally have to initiate a payment or make a check to repay the lending. The loans are repaid automatically in the form of a single monthly payment from the bank account of the borrower. A reminder is sent to the borrower a few days before the loan amount is due to ensure that there are enough funds in the account to make the repayments. In most cases there are no penalties for early payment of the loan. Individuals can pay off the loans any time to save cost of interest charges.
Fees and Charges
Apart from the origination fee, the lending platforms may charge other servicing fees from the borrowers. Some of the fees and charges that are charged by P2P lending firms are listed below.
Unsuccessful Payment Fee
The unsuccessful payment fee is charged in case the borrowers' bank rejects the request for transfer of loan amount when it becomes due. There may be different reasons for the unsuccessful transfer of loan amount from the borrowers account such as insufficient funds, or suspension and closure of bank account.
Whatever the reasons for the rejection of payment transfer request from the bank, the borrower is liable to pay the fee to the lending platform. The exact fee amount differs but is usually about $15. This fee covers the costs incurred by the lending platform due to unsuccessful transfer of the amount. The lending company may try to recover the loan amount for up to two additional times. Each attempt to recover the amount by the lending platform will result in levy of additional Unsuccessful Payment Fee.
Check Processing Fee
Check processing fee is charged in case the lending platform allows repayment of the loan amount through a check. Processing of the check incurs extra cost for the lending platform. That is why borrowers are required to pay additional fee in case they opt to repay the loan through a check, which is usually around $7.
Late Payment Fee
The third common fee that is charged by most lending firms is the late payment fee. These fees are charged if the borrower is unable to repay the amount after the grace period allowed for the loan repayment. Borrowers will incur no costs if the loan is repaid within the grace period. However, once the grace period is over they will have to pay a late payment fee that is usually 5% of the unpaid balance or $15, whichever is greater. The fee is charged only once the borrower defaults on the loan, though the APR tends to accumulate until the loan amount is repaid in full.
Peer-to-Peer Lending: What's in it for the Investors?
P2P lending companies in the US have to register with the SEC according to the Securities Act of 1933. This requirement was set in place by the federal regulators right after the 2008 crises that had rocked the financial world. The lending is legally treated as an investment with the repayment of the amount insured by the federal government (read: FDIC) similar to the way deposits are.
The reason P2P lending is classified as an investment is because unlike banks and other similar financial institutions investors can choose whether to lend money to riskier borrowers with high returns or less risky borrowers with low returns. Some of the advantages of P2P lending to individual and institute investors are as follows.
P2P lenders are mostly private individual investors but may also include institutions. An attraction for the investors in this kind of investment is the high level of transparency. They can control the investment amount along with the risk level they are willing to take on.
Another appealing factor for the investors is the diversification ability that is not present with other types of lending investment options. Investors can distribute their investment amount over different loan types that further lessens the risk. They also have the option to either accumulate the investment returns or reinvest them in other loans.
One of the advantages of P2P lending for lenders include higher returns as compared to bonds and other similar fixed investment instruments. The investing platform provides better return to the investors that range from 5% - 9%. This is one of the major reasons for the increasing popularity of P2P lending platforms amongst investors.
Low Risk of Default
Another benefit of P2P lending is that there is low risk of default on loans. The default rate of Prosper and Lending Club was 4.24% and 3.86%, respectively, in the third quarter of last year4. Upstart, on the other hand, reported a default rate of zero during the same period. Additionally, some of the lending platform requires each of the borrowers to make a contribution from which the lenders are recompensed in the event of a default. This further lowers risk for the investors as they are likely to be remunerated in the uneventful case of a default.
Another attraction of P2P lending in the US is that it encourages socially conscious investing. This is great for investors who want to earn money as well as contribute to the society. Through the lending platform investors are able to support individuals in making their business idea a success, get free from the shackles of high interest rate debts, and allow individuals to meet their essential financial obligations.
Apart from investors, P2P lending also attracts borrowers for a number of reasons. They usually are able to obtain the loans on better terms and conditions as compared to conventional loans. Additionally, borrowers can obtain the loan amount whether they get a good or bad credit score. Although, having a good credit score correlates to paying less finance charges on the loans. Lower credit scores on the other hand reflect riskiness of the individual borrowers due to which they are charged a higher rate.
Risks to P2P Lending Industry
The P2P lending industry in the US is expected to rise in the near future. That being said there are certain risks that are faced by the industry at the moment. Firstly, the P2P lending industry has come under close scrutiny of the regulators after it was known that the San Bernardino shooter who had put to death 14 people in his killing spree in December 2015 had obtained a loan of around $28,500 from Prosper5. Although, the online lending platform is not facing any public investigation at the moment, regulators must now be looking for ways to put checks in place to screen borrowers and ascertain the purpose and usage of loans.
Experts believe that another threat faced by the industry is the increase of interest rate by the Fed. Federal Chairman, Janet Yellen, announced last year that the Fed intends to increase rates gradually in the coming years. Increases in rates will increase the risk of loan defaults. This will make the lending platform less appealing to investors. That being said, as long as the economy is in good shape and the employment level remains at a reasonably high level, the rate of default should not rise drastically.
Finally, competition from banks also presents a risk for existing players in the lending industry. Last year Goldman Sachs announced that it wants to build its own P2P lending site6. Most major banks however, decided to partner with existing lending companies. For instance, JP Morgan announced entering into the P2P lending boom by partnering with OnDeck Capita for offering loans of up to $250,0007. Additionally, banks like Credit Suisse, Silicon Valley Bank, Norwest Venture Partners and BBVA have directly invested in Prosper and Lending Club funding plans.
The phenomenal success of the P2P lending industry in addition to recent high profile public offering has caught the attention of portfolio managers working for large financial institutions, which has further strengthened the already dynamic industry. Today the industry comprises both private and institutional investors.
In the near future, we may see increasing number of lending firms entering the P2P lending industry. Moreover, financial experts are predicting that a number of existing lending firms such as Prosper, Kabbage, Avant, and Sofi will most likely have IPOSs in 2016. Whatever the future holds for the industry, one thing is certain that the P2P lending industry will continue to make waves in the coming years.
The fact is, P2P lending investment is not for everyone. But it will continue to grow faster than traditional loans and bonds as long as the returns of these instruments remain at a subdued level. The growing participation from large institutional investors is a strong validation that P2P lending is here to stay, at least in the US for the foreseeable future.
Disclaimer Notice: The article is intended for informational purposes only. We are not liable for any loss or damage incurred due to the implicit or explicit information provided in the article.
Written by Naeem Ghauri, Founder and Head of Global Sales
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