The definition of P2P Lending is the lending of an individual or business by
a set of lenders without the mediation of a bank or another traditional financial institution.
How does it work?
The peer-to-peer lending process in three parts:
1. The borrower
2. The investor
3. And the platform
The borrower chooses the platform on which he will make his application depending on its needs and the purpose of its funding. After he does the request, the data are studied by the staff of the platform. Then the credibility of the borrower is confirmed or not.
In the application, apart from the personal data, the following are also recorded:
- The exact amount of money desired by the borrower.
- The purpose of its financing (mortgage, consumer loan, etc).
The process of verifying an honest lender does not affect the next stage of the process. The next step is rating its creditworthiness. At this stage, the borrower is rated according to his financial features, as in a bank, with an accurate rating, and then is ranked in a wider scoring group (A, B, C…). An external service rates the borrowers. Then a second grade is obtained from its staff platform. The final score will be the result of both scores as well as additional information—for example, the possible borrowing from other platforms in the past.
His scores will determine the interest rate at which he will receive the loan. It is worth mentioning that there is a lot of discussion about the wider ranking of scores, as the groups that are created, present very different characteristics (due to the large scoring range of the team) as a result the final score is not correct. The loan is then “online” on the platform’s website and it is now “available” to investors for financing. The concentration of the requested amount of money takes a predetermined period which takes about three months.
Finally, when the amount is enough to cover the demand, the offers close. A big advantage of the service is that the borrowers can do repayments of their loans earlier without extra charges.
Investors follow a very simple process to create an account on the platform they wish to invest. They give them their personal information, as well as an electronic account. In addition, it is mandatory for them to provide additional information. The tax registration number and the bank account number are what they will use for their transactions. After filling in the details and creating the account, they can start creating the portfolio.
The portfolio “in three ways”:
1. By selecting the desired loans from the investor himself
2. By purchasing already-made ‘packages’ of loans
3. By creating a ‘package’ of loans according to their criteria.
Creating a well-structured portfolio in any investment is very important to achieve by investors to achieve their goals. But in the case of putting money on a peer-to-peer lending platform where the investor does not contact a financial advisor, the risk of making a wrong decision increases. For this reason, many platforms offer webinars that try to present basic investment principles like portfolio diversification and understand the need to create an investment strategy. They also inform them about the risks taken by the investor and the different forms of risk depending on the loans they choose to finance (credit, probably monetary, etc).
The platform hosts trading parties and tries to serve their needs in the most efficient way. The online version of the platform has brought in quite a several contacts to make this model more applicable to become widely known and accepted easier. In earlier times borrowers could turn mainly to people they knew and in fact, they had to maintain such a close relationship that they trusted him with their money. Instead, it now addresses all the individuals of a country or on certain platforms that enable international loan selection, internationally.
Apart from the basic principle of contact between the two parties, the platforms began to evolve their services to avoid unpleasant situations such as trying to deceive their customers. For this reason, they request documents from the borrowers to confirm the authenticity of the information given to them. The more validated a borrower gets, the higher the probability of the success of financing his loan, as investors feel more confident about him.
Creating and offering ready-made portfolios, through applications, for investors is one of the biggest steps in its development platform and the peer-to-peer lending model in general. These portfolios are a good solution for service users who do not have the financial knowledge and want to enjoy the advantages of the service. They also replace the service consultants with a free service, thus reducing their cost investment. Reducing credit risk is another problem that some platforms tried to resolve.
A basic tool against the bankruptcy of the borrower is differentiation. Some platforms even claim that they can help investors not only avoid losing part of their capital but also avoid affecting the percentage of their performance to a significant degree. They achieve that by using their applications to create diversified portfolios. An important development is the creation of a chapter from several platforms, which has part of his money to cover losses from borrowers’ bankruptcies. In 2010 RateSetter was the first platform that provided this service.
The lending Works platform was the first to provide security against credit risk with capital insurance. The creation of a secondary market is offered by some platforms. Prosper and the Lending Club were the pioneers of P2P. In collaboration with the investment company, FOLIOfn made it possible to buy and sell loans after they had been funded. This opportunity attracted more investors as it created liquidity in the securities market that negotiated and enabled the liquidation of positions. Nowadays there are many alternatives to raising money like crowdfunding but don’t forget that with P2P lending both sides could benefit from this situation.