Peer-to-Peer Lending: The Good, the Bad and the Unknown
If you're an entrepreneur in search of capital, the truth is that banks don’t really want to loan you moneyunless you have met credit requirements and have enough assets to cover the loan amount in the event of a default. An angel investor is another dicey option: They an be a great source of capital if you can find one, but VCs are usually interested in big ideas that guarantee high returns.
For many entrepreneurs, this reality makes it difficult to raise funds for a new venture, but peer to peer (P2P) lending is on the rise, opening financial doors for small businesses and creating a scenario where everyone wins.
In a nutshell, P2P lending links investors with entrepreneurs to start or expand a business. And the good news is that there are many P2P platforms out there ready to serve as intermediaries between the two groups and match loan applications with those willing to take a chance on that particular investment.
The process is entirely digital, with the entrepreneur applying online on the P2P site of his or her choice and providing basic documentation, making the application more streamlined than a banking application. The P2P application is then reviewed by potential investors, and funding may be received is as little as 72 hours.
This industry experienced an annual growth rate of 513 percent between 2013 and 2018, according to IBISWorld. To be sure, P2P lending serves a clear, unmet need, but there are good, bad and unknown factors that impact entrepreneurs and investors alike.
Peer-to-peer lending fills a void in the marketplace and is a natural extension of the sharing economy. It brings investors and business people together to create a mutually beneficial arrangement without extensive red tape, which amounts to a a win-win for both parties.
For entrepreneurs, P2P lending offers access to funds they could not receive through a bank either because they would not qualify for a loan or because the loan amount is too small to be financially beneficial to the lender.
The denial rate of P2P loans is much lower than that of banks due to the collective nature of these loans. In addition, such transactions may create long-term relationships between entrepreneurs and investors, giving the former group access to additional funds over time. Further benefits to entrepreneurs include lower interest rates than those at banks, a quicker application experience and less cumbersome paperwork.
For investors, P2P lending allows the ability to diversify their portfolio in new and exciting ways. Depending on the P2P lending platform used, you can open an account with a minimum of $1,000 and invest $25 or more in a single note, making these opportunities available to smaller investors who might otherwise have difficulty participating in this type of investment.
In addition, more than 80 percent of active investors met or exceeded their expected return on investment on some P2P lending sites.
Though there are many great P2P lending opportunities, this option isn’t perfect. The biggest challenges for entrepreneurs include:
- The loans are for a small amount. Loan ceilings are often limited to $35,000, though that figurevaries by lending site. While this is a significant amount of money, it might not be enough for entrepreneurs to really get their idea off the ground or take it to the next level.
- A P2P s a personal loan.And these lending sites are not set up to directly loan money to a small business. Accordingly, these are personal loans, so the entrepreneur must provide personal financial information, including access to their credit reports. As more companies request those credit scores, the outcome can be negative, making it difficult for these entrepreneurs to secure other funding later.
- There are fees. Usually, this means a 5 percent closing fee, which is deducted from the loan amount.
- P2P is not legal everywhere. While most states do allow this kind of lending, not everyone is on board with its new financial structure. In this context, P2P lending map is constantly changing, so entrepreneurs need to do their due diligence before committing to this process.
For investors, the biggest challenge is that the process takes time. Each opportunity must be evaluated and there are no guarantees that the borrower is telling the truth. Other issues include: the fact that these are unsecured loans, that defaults do occur and that there is a lack of automatic reinvesting.
The P2P lending industry reached $3 billion in the U.S. market in 2018 and is currently unregulated. As these numbers continue to rise, and they are expected to do so, it is possible that federal and state government agencies will step in with regulations to better protect investors and establish various requirements. If and when that happens, ithe landscape of P2P lending will change, making P2P less accessible to those entrepreneurs who rely on it the most.