Peer To Peer Lending and Crowdfunding Vs Traditional Finance
With the popularity of peer to peer lending or crowdfunding over the last few years, we start to see the pros and cons of investing and borrowing in this sector and naturally compare this to the more traditional financing route, namely the banks.
Just look at the press this year, there are more and more articles, advertisements and promotions to entice investors to lend and participate and for borrowers to seek alternative financing but what, why and how do they differ from traditional loans and lenders and what should we all be mindful of when making this commitment?
Firstly, what is peer to peer lending or crowdfunding?
Peer to peer (or P2P) lending is not quite like other investment types. As a consumer, you can become a lender through companies, which are generally known as P2P platforms, like Lending Club and Funding Circle to name just two of many (as an example) and earn interest on loans repaid to you.
Simply, you register your details to become a lender and get pre-approved by the online checks required including profile ID and anti-money laundering (AML). Once this has been passed, you can start to view the deals or projects, do some research, perhaps ask questions and then make a pledge to participate as a collective lender to the loan deal.
It’s the collection of lenders like you that come together and the total pledges made to meet the targeted total a borrower has also applied within the same platform once filled can be legally ratified and the loan begins.
Each P2P platform and even on a deal by deal basis, the terms will vary including the term, the rate of interest agreed and any other exiting options and possibly ongoing costs associated with the platform or loan.
To understand more about our workflow, I recommend you review our peer to peer lending FAQ sections.
However, there are some risks in peer to peer lending and crowdfunding.
Despite the risks, investors are still interested in it because it can expand your portfolio beyond stocks and bonds, and it has a potential higher rate of returns since the risk of lending to people or businesses outside the traditional financial channels is deemed higher.
Of course, it goes without saying that with any other type of investments, it is ideal to research and understand the risks before wading in.
Make sure any money you put in as investments is money you are willing to lose, completely, because it can happen.
Successful peer to peer platforms must promote well-established, transparent relationships with funders and guarantee that they realise the risks and are aware of the processes that are used to handle those risks.
Peer to peer lending and crowdfunding has given hope to general savers who are seeking a better return on their money and as a caution, lenders and borrowers really should be only considering authorised and approved P2P platforms which is governed by Financial Conduct Authority (FCA) and is actually illegal for consumers (lenders) to be invited to participate in an unregulated arena.
New regulations are implemented for platforms that fall short of its requirements to be “clear, fair and not misleading”. The FCA have a strict policy for customers known as TCF – Treating Customers Fairly.
So, the key difference and a ‘loose’ distinction between peer to peer lending and crowdfunding can be summed as follows:
Peer to peer lending is a loan-based function offering normally a fixed rate of return over a fixed term with scheduled repayments detailing the interest and principal amounts. By the very essence a loan is a legally binding agreement between borrower and the participating lenders which must be repaid and in some cases, depending on the deal and product, some loans can be provided with security (like a first charge over a property) to add a layer of protection for lenders should the borrower default on the loan.
Crowdfunding is an equity-based function offering speculative returns by way of shares in a new venture, business or product and comes in many forms. This is very different from a traditional loan agreement that either a P2P or traditional lender will invoke. There’s a higher risk on this type of investment but that comes with potentially higher returns too.
As already mentioned, please do your research first into the different models around and get some financial advice from an authorised FCA agent before signing up.
Traditional Finance
Banks and mortgage lenders are still lending but have become more selective in what and how they process applications which is going to get tougher (especially for mortgages) with more restrictions being imposed later in the year.
But the challenge with the banks when applying for a loan is you, the applicant must fit into many boxes to be approved and the P2P and crowdfunding models offers a different and alternative approach to assessing risk and tends to understand the business or individual needs more than a bank could which can be seen as too automated and systemised by comparison.
Of course, one could argue the reason a borrower has approached a p2p platform at all is due to the failure of perhaps getting the traditional finance via a bank in the first place which may be deemed as a red-flag to the applicant’s profile but generally this not the case, it’s a far simpler reason why they were unsuccessful.
Banks are conventional institutions which uses their own ring-fenced funds, ironically some from very same savers who are getting very poor returns on their savings making more profit from a wider spread between offering savers and borrowers.
With peer to peer lending, the lenders are invited to be the ‘bank’ and take a better slice of the profits with rates typically marketed at around *6% per annum.
There’s a new market for businesses to raise alternative finance and the banks along with the media are slowly accepting this reality and the new way forward – it’ picking up momentum and is here to stay!