Peer-to-Peer Lending

Peer-to-peer lending, also called marketplace lending, is a model in which an online platform connects people who want to lend money with people or small businesses who want to borrow it, cutting a bank out of the middle. Borrowers apply through the platform, which grades their creditworthiness and sets a rate; lenders fund the loans, often in small slices spread across many borrowers, and receive a share of the interest and principal as it is repaid. The platform earns fees for originating and servicing the loans and for running the marketplace.

From the lender's side, which is the focus here, peer-to-peer lending is an investment in unsecured consumer or small-business debt. The promised yield is higher than a savings account precisely because the risk is different: the money is not a bank deposit, it is not insured, and the return depends on borrowers actually paying. This is a separate thing from a peer-to-peer payment app, which simply moves money between individuals and involves no lending or investment at all; the shared "peer-to-peer" label is the only connection.

The economics of lending on these platforms come down to whether the interest collected outruns the loans that go bad. A platform may advertise borrower rates well above what safe fixed-income pays, but a portion of any pool of unsecured consumer loans will be charged off, and the lender's real return is the interest received minus those losses minus servicing fees. Because the loans are unsecured, a default usually means little or nothing is recovered. Spreading money across many small loans reduces the chance that a single bad borrower dominates the outcome, but it does not remove the risk that defaults across the whole pool run higher than expected, which tends to happen exactly when the economy weakens and borrowers lose jobs.

Two structural risks sit on top of borrower default. The first is platform risk. In the common United States structure, a lender does not hold a direct claim on the borrower; they hold a note issued by the platform whose payments depend on the underlying loan. If the platform itself fails, collecting on those loans, and even establishing who is entitled to the payments, can become slow and uncertain. The second is liquidity risk. These notes are not traded like stocks; a lender generally commits money for the life of the loan, and where a secondary market to sell early has existed at all, it has been limited and at times shut down entirely.

The industry's own history illustrates the point. LendingClub, an early leader founded in 2007, stopped offering notes to individual retail investors at the end of 2020 as it acquired a bank and pivoted to institutional funding, and it discontinued its secondary trading venue that same year. Prosper remained open to individual investors. The broad direction has been that the model started as a way for ordinary people to lend to one another and has increasingly been funded by institutions instead, which is worth knowing because it means the access, terms, and protections a retail lender encounters have shifted over time and are not fixed.

A lender funds an account on the platform and either picks individual loans or lets the platform allocate the money across a set of them according to chosen risk criteria. Each loan carries a grade and an interest rate. As borrowers make monthly payments, the lender receives a proportional share of principal and interest, net of the platform's servicing fee, and can reinvest it or withdraw it.

A hypothetical example shows why the advertised rate is not the return. Suppose a lender puts $10,000 into a pool of three-year consumer loans with an average stated interest rate of 10 percent, so the gross interest in a year is roughly $1,000. Now suppose that over that year borrowers representing about 6 percent of the principal default and little is recovered, a loss of about $600, and the platform charges servicing fees of about 1 percent, or $100. The net result is roughly $1,000 minus $600 minus $100, about $300, or a 3 percent return, less than a third of the headline rate. The figures are invented, and real default rates vary widely with credit quality and the economy, but the arithmetic, interest minus defaults minus fees, is the whole game.

Potential advantages

• Interest rates that can exceed those on savings accounts and high-grade bonds, as compensation for taking credit risk.
• The ability to spread money across many small loans, reducing exposure to any single borrower.
• Access to a form of consumer-credit return that was historically available mainly to banks and institutions.

Risks and drawbacks

• No deposit insurance. Defaults are the lender's loss, and unsecured loans usually recover little when they go bad.
• Returns are highly sensitive to the economy; defaults rise in downturns, just when other assets fall too.
• The money is generally locked up for the life of the loans, with limited or no way to sell early.
• Platform risk: a lender often holds a note from the platform rather than a direct claim on the borrower, so a platform failure can jeopardize repayment.
• Interest received is taxed as ordinary income, and defaulted loans get only limited tax relief.