Red flags of peer-to-peer lending

Peer-to-peer (P2P) lending is an alternative borrowing option to traditional loans, letting people borrow from other individuals rather than banks or financial institutions. Plus, it offers a potential opportunity for individual lenders, also called investors, to yield generous returns on their money.

However, not all peer-to-peer lending companies are created equal, and the burden of due diligence sits squarely on the shoulders of prospective borrowers and lenders. That’s why it’s important to look out for potential red flags, like additional fees, higher interest rates and lack of FDIC- insurance.

Red flags in peer-to-peer lending for borrowers

Borrowers may find P2P lending a great option if they are short on cash, but there needs to be an increased vetting process before applying for a P2P loan. To reduce the risk of financial harm down the road, borrowers should ensure they are using a reputable lending platform and need a plan in place should they run into any of these red flags.

Borrowers may need to pay additional fees

“If you’re fed up with bank fees, you’ll really hate P2P loans,” says Howard Dvorkin, CPA and Chairman of Debt.com. “On top of the interest rate you’ll pay, there’s the origination fee, which can be as low as 1 percent but as high as 8 percent. That’s much more than a bank or credit union will charge you for a personal loan.”

Traditional personal loans can come with late fees, origination fees, prepayment penalties, non-sufficient fund fees and processing fees. While each fee is often on the lower amount — for example, late fees are often $39 — over time, they add up. Plus, if you have lower credit, the fees will often be even higher on top of higher rates.

That said, P2P loans charge high origination fees and may charge fees similar to personal loans. Before applying for a P2P loan, comb through the terms and conditions to ensure you’re aware of every fee charged and be on the lookout for hidden fees.

Borrowers may get worse rates than with traditional loans

P2P loans can sometimes have lower rates than traditional ones, but borrowers should research. You can often get similar or lower rates with a traditional lending institution. You can often get rates similar to or lower than those of a traditional lending institution. Dvorkin says it can be tricky to determine if rates will be lower because P2P loans are often marketed to have lower interest rates than traditional lenders.

Before applying, crunch the numbers and consider all your lending options to ensure you get the best rate for your credit score. For example, investigate loan rates at local lending institutions, like banks, credit unions and online lenders. Often, online lenders offer the lowest interest rates, with some offering loans to individuals with lower credit scores.

Less support if there is difficulty paying the loan

If a borrower cannot pay off a loan within the agreed-upon terms, lenders have a right to pursue legal action to satisfy the delinquent payments. A traditional bank might offer support such as a payment plan or a longer period to repay the loan before sending a loan to a debt collector. However, peer-to-peer lenders may send a defaulted loan to a collection agency in as little as 30 days.

If your payments are late, a P2P lender may raise interest rates or add fees. If you plan to borrow using a P2P loan, know the terms you are signing up for. A traditional lender could be more lenient with an unpaid loan, but a P2P lender will likely take action against a defaulted borrower more quickly.

Red flags in peer-to-peer lending for lenders

Like most investment opportunities, lenders — or investors — face potential hazards in peer-to-peer lending. If you are interested in becoming an investor in P2P loans, you can have significant returns for your investment, but you should also know the risks you assume when you become a lender.

• If the borrower defaults, lenders often lose their money. While some peer-to-peer loans are secured, they are most often unsecured loans. This means the borrower isn’t borrowing against any collateral, and if they can’t pay their loan, the lender loses their money.
• Loans are not typically FDIC-insured. A loan with a traditional bank is FDIC-insured, but many P2P loans are not. This means that lenders don’t have the guarantee of seeing their loaned money again like they would with other deposits or investing opportunities.
• Returns may be lower for the lender if the borrower pays early. If the borrower pays the loan early, you’ll get the original investment back in your account, but the returns will ultimately be lower. While this may seem positive, it means that the loan funds are no longer earning interest.

When is a peer-to-peer loan a good idea?

These loan products could be ideal for both borrowers and lenders for many reasons. For one, P2P lending often offers lower interest rates for borrowers with good credit scores than traditional lending intuitions.

That said, if borrowers don’t have great credit, P2P lending may allow them to get a loan when a bank might not approve them. These loans are commonly used to cover automobile purchases, home improvement costs, moving expenses, fertility treatments and other big-ticket costs. If you plan to start or grow a business, they can also serve as a funding source.

P2P loans could make sense for lenders seeking higher returns than they could with other investing options. Typical returns for P2P investors per year average about 5 percent to 9 percent, while some investors see 10 percent or more returns.

Bottom line

P2P loans can be a great option for both borrowers and lenders. That said, both should carefully weigh the pros and cons when deciding if these types of loans are right for them.

Borrowers should watch out for extra fees or rates comparable to other lenders. P2P investors need to be aware of the financial risks they are taking and understand the returns they may receive compared to other investments.