What Is Peer-to-Peer (P2P) Lending? Definition and How It Works

What Is Peer-to-Peer (P2P) Lending?

Peer-to-peer (P2P) lending enables individuals to obtain loans directly from other individuals, cutting out the financial institution as the middleman. Websites that facilitate P2P lending have greatly increased their adoption as an alternative method of financing.

P2P lending is also known as “social lending” or “crowd lending.” It has only been around since 2005, but the crowd of competitors already includes Prosper, Lending Club, Upstart, and Funding Circle.

Key Takeaways

  • Peer-to-peer (P2P) lending is a form of financial technology that allows people to lend or borrow money from one another without going through a bank.
  • P2P lending websites connect borrowers directly to investors. The site sets the rates and terms and enables the transactions.
  • P2P lenders are individual investors who want to get a better return on their cash savings than they would get from a bank savings account or certificate of deposit.
  • P2P borrowers seek an alternative to traditional banks or a lower interest rate.
  • The default rates for P2P loans are much higher than those in traditional finance.

Understanding Peer-to-Peer Lending

P2P lending websites connect borrowers directly to lenders. Each website sets the rates and the terms and enables the transaction. Most sites have a wide range of interest rates based on the creditworthiness of the applicant.

First, an investor opens an account with the site and deposits a sum of money to be dispersed in loans. The loan applicant posts a financial profile that is assigned a risk category that determines the interest rate the applicant will pay. The loan applicant can review offers and accept one. (Some applicants break up their requests into chunks and accept multiple offers.) The money transfer and the monthly payments are handled through the platform. The process can be entirely automated, or lenders and borrowers can choose to haggle.

Some sites specialize in particular types of borrowers. Funding Circle, for example, focuses on small businesses. And Lending Club has a “Patient Solutions” category that links doctors who offer financing programs with prospective patients.

History of Peer-to-Peer (P2P) Lending

Early on, the P2P lending system was seen as offering credit access to people who would be spurned by conventional institutions or a way to consolidate student loan debt at a more favorable interest rate.

In recent years, however, P2P lending sites have expanded their reach. Most now target consumers who want to pay off credit card debt at a lower interest rate. Home improvement loans and auto financing are also available at P2P lending sites.

The rates for applicants with good credit are often lower than comparable bank rates, while rates for applicants with sketchy credit records may go much higher. LendingTree.com, for example, listed personal loan rates from 4.60% to 36% as of July 12, 2023. The average credit card interest rate was 20.82% as of July 20, 2023, according to CreditCards.com.

For lenders, P2P lending is a way to generate interest income on their cash at a rate that exceeds those offered by conventional savings accounts or certificates of deposit (CDs).

Some P2P sites allow lenders to start with an account balance of as little as $25.

Special Considerations

People who wish to lend money through a P2P lending site need to consider the possibility that their borrowers will default on their loans, just as conventional banks do. Research on P2P lending platforms has indicated that defaults are much more common than those facing traditional financial institutions, sometimes in excess of 10%.

By comparison, the S&P/Experian composite index of default rates across all types of lending to U.S. borrowers has fallen from about 1.42% to 0.72% over the ten years prior to June 2023.

Any consumer or investor considering a P2P lending site should also check the transaction fees. Every site makes money differently, but fees and commissions may be charged to the lender, the borrower, or both. Like banks, the sites may charge loan origination fees, late fees, and bounced-payment fees.

Is Peer-to-Peer Lending (P2P) Safe?

Peer-to-peer lending is riskier than a savings account or certificate of deposit, but the interest rates are often much higher. This is because people who invest in a peer-to-peer lending site assume most of the risk, which is normally assumed by banks or other financial institutions.

How Big Is the Market for Peer-to-Peer (P2P) Lending?

The global peer-to-peer lending market was worth $134.35 billion in 2022, according to figures from SNS Insider. This figure is projected to reach $705.81 billion by 2030.

How do You Invest in Peer-to-Peer Lending?

The simplest way to invest in peer-to-peer lending is to make an account on a P2P lending site and begin lending money to borrowers. These sites typically let the lender choose the profile of their borrowers, so they can choose between high risk/high returns or more modest returns. Alternatively, many P2P lending sites are public companies, so one can also invest in them by buying their stock.

The Bottom Line

Peer-to-peer lending sites offer options for entrepreneurs, small businesses, and individuals that might not fit the profile of the ideal loan recipient by traditional banking standards. While P2P lenders may extend credit more easily, it comes with higher fees and interest for borrowers and a higher risk of default for lenders. Many P2P platforms make it easy to invest or borrow, but read the fine print to learn about all the associated fees before signing anything.

Article Sources
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  1. Funding Circle. "About Us."

  2. Lending Club. "Patient Solutions."

  3. LendingTree.com. "Compare Personal Loans for July 2023."

  4. Creditcards.com. "Average Credit Card Interest Rates: Week of July 19, 2023."

  5. Springer Open. "How Does an Individual's Default Behavior on an Online P2P Lending Platform Influence an Observer's Default Intention?"

  6. S&P Dow Jones Indices. "S&P/Experian Consumer Credit Default Composite Index."

  7. SNS Insider. "Peer To Peet Lending Market."

  8. Precedence Research. "Peer-to-Peer Lending Market."

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