Pros and Cons of Peer-to-Peer Lending for a Small Business
The peer-to-peer (P2P) lending business model enables small businesses (SMBs) to raise capital without necessarily approaching traditional lenders such as banks. More specifically, this business model gives entrepreneurs an online platform they can use to communicate and solicit funds directly from potential investors.
To learn more, check out the infographic below created by Norwich University’s Online MBA program.
An Overview of P2P Lending
Modern P2P lending activities normally take place online where borrowers and lenders join P2P online platforms such as Prosper and Lending Club. People typically register as either borrowers or lenders. After joining, a borrower submits a loan application for review along with a plan detailing how he/she intends to spend the money raised. This stage normally determines whether a loan application is viable and aligns with the borrower’s investment strategies. Upon accepting a loan application, the review team publishes it on the P2P platform so that it is visible to all investors. In most cases, a loan application remains visible until it is fully funded or taken down by either the borrower or the P2P lending platform.
Differences Between P2P Lending and Traditional Financing
For starters, P2P lending platforms run their operations entirely online. As such, they typically have minimal personal contact between both borrowers and investors. Moreover, they require minimal personal information from the parties involved, which is considered good news for advocates of digital privacy. Another major difference between P2P platforms and mainstream lenders is that the P2P platforms do not lend their own money. Instead, they act as matchmakers that bring borrowers and lenders together. Nevertheless, P2P platforms offer investors some degree of assurance in the form of security notes that can be purchased on their sites. Unlike traditional financiers, P2P lending offers better interest rates, making the service highly attractive to value investors. In general, P2P lending offers better returns than financing opportunities offered by traditional lenders.
P2P Lending Platform Revenue Models
Like most web platforms, P2P platforms must generate revenue to cover their operational costs. Firstly, loan applicants are charged origination fees that vary depending on factors such as platform policies and the total loan amount. In addition, P2P lenders generate revenue by deducting and retaining a percentage of the interest charged to investors. You can think of these deductions as loan servicing fees. Peer-to-peer lenders also earn money via late fees.
Compared to borrowing funds from a traditional lender, P2P loan application and processing is much faster. In fact, most loan applications are approved or denied almost instantly and those that make it through the approval stage are usually processed within two weeks. The collective funding approach underpinned by the P2P lending model protects investors from crippling financial losses. Small businesses also benefit immensely because they can easily access funding even with a poor credit history. Additionally, the minimal paperwork involved means fewer bureaucratic processes. Another major benefit is the lower likelihood of loan denial. Finally, the peer-to-peer lending model is predicated on a simplified customer experience. For instance, most P2P financing platforms are accessible via dedicated mobile apps, meaning investors can review funding applications while borrowers can check interest rates and application updates from the comfort of their homes.
In spite of its benefits, the P2P lending industry is a relatively new financial model that is yet to be comprehensively regulated. This means investors may be unable to accurately determine the default risk of borrowers. It is also worth noting that borrowing funds via P2P lending platforms could substantially hurt your credit score because such platforms are set up to accept individual borrowers, not legal entities such as small to medium enterprises. This is particularly important because a low credit score would make it difficult for you to access financial services from mainstream lenders. P2P platforms also do not cultivate relationships with borrowers or lenders, which is the opposite of the know-your-customer approach adopted by banks. For this reason, there is little information about the P2P lending industry compared to the traditional financial sector. This aspect alone can have a negative impact on interest rates.
P2P Lending Statistics
The P2P lending industry dates back to 2005 when the first platform, Zopa, was launched in the UK. Shortly thereafter the Lending Club and Prosper, among others, were launched in the US. Since 2007, the volume of transactions via US-based P2P lending platforms has grown by 84% with loans worth $5.5 billion issued in 2014 alone. By 2025, the P2P lending industry will reach $150 billion or more. Some of the leading players in the P2P SMB lending space include Kabbage, Funding Circle, and OnDeck. OnDeck went public in December 2014 and boasts a market valuation of $1.8 billion, while Kabbage has raised $135 million in seed funding at a valuation of $1 billion. The Funding Circle has raised $150 million from investors at a valuation of $1 billion.
P2P Lending Trends
There is no doubt that advancements in information and communication technologies (ICTs) have boosted the fortunes of the P2P lending industry. As such, it is quite popular with tech-savvy Millennials who also account for 15.7% of small business owners. This was confirmed by a survey carried out by Morgan Stanley, which found that Millennials prefer faster, cheaper, and more convenient forms of credit. In addition, Millennials more than any other American age demographic favor web transactions conducted via mobile apps. Compared to Generation X, for instance, Millennials running small businesses are five times more likely to seek funding via P2P platforms.
The peer-to-peer lending business model is a novel capital-raising model that enables entrepreneurs to seek funds from a group of investors. Some of the key benefits of P2P lending include minimal paperwork, low interest rates, low risk of loan denial, simplified customer experience, and faster loan application processing. Nevertheless, P2P lending has drawbacks including lack of proper regulatory frameworks, minimal or no personal interactions, and high likelihood of negative credit score impact. In spite of these challenges, the P2P lending industry is growing fast, especially in the US where platforms such as the Funding Circle and Kabbage disbursed loans worth $5.5 billion in 2014 alone.
This article was contributed to us by Norwich University
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