Five years ago, borrowing a cup of coffee was almost unthinkable. Now, Millennials make more coffee loans per week than Starbucks, a trend that’s pushing peer-to-peer lending sites like Acorns, Kiva, and SoFi towards ubiquity.
However, in 2017’s second quarter, the cash provided by traditional sources from banks and credit unions increased by 3.2% year-over-year (YoY) to a total of $32.37 trillion, according to data from the Federal Deposit Insurance Corporation (FDIC).
On the contrary, the cash borrowed from third-party peer-to-peer lenders fell by 9.7% YoY to $3.37 billion, while the total number of loans made grew to 1.73 million.
When compared to the total amount of loans facilitated by banks and credit unions ($6.47 trillion), a one-percentage-point gap is a huge difference in return on investment.
Yet, when you look at the latest trends in personal finance, it’s clear that peer-to-peer lending remains relevant.
Today, I want to explain what peer-to-peer lending is, the role that it plays in personal finance, and my thoughts about where it will be in 2021.
What Is Peer-to-Peer Lending?
When I hear “peer-to-peer lending,” I picture a sea of young millennials standing outside a Starbucks, flipping through their wallets in search of loose change, looking for a charity they know will accept dollar bills.
P2P lending doesn’t work that way. Instead, it involves connecting small investors with small businesses. Here’s how it works:
Small investors, typically with an income of $50,000 or less, can apply for funding, so there’ll be no start-ups for something like a new online casino and such big projects. The business then pays interest to investors to invest in its products or services.
The business can either invest their own money (sometimes called angel investing) or raise money from the general public (equity crowdfunding).
The investor-recipient relationship is one of equals. In theory, they should be able to have a one-on-one relationship with the small business they’re funding.
P2P Lending is Distinct from Crowdfunding and Lending Club.
Lending Club is the best-known crowdfunded company in the U.S., but its investment returns have not met its own expectations. The primary reason for this is that the investor base was far too diverse, with about 8% of the investors receiving only their principal. Investors also may be faced with hefty fees and hidden costs that can reduce their returns.
Crowdfunding involves raising money from many investors, in order to raise a sum large enough to acquire a product or service. Lending Club, on the other hand, requires that the investor have a credit score of at least 750, a place to live, and an income. As you can imagine, the types of investors you’ll find on Lending Club are more traditional.
All three types of loans are peer-to-peer lending. As it happens, a reader of this blog works for a peer-to-peer lending site called SoFi, which connects borrowers with institutional investors.
Since the global financial crisis of 2008, P2P lending has grown to become the fourth-largest asset class in the world. (Lending Club alone holds more than $12 billion in loans.)
In 2017, annual loan volume in P2P was at $169 billion, a 26% increase from the previous year. The majority of this growth is expected to come from Asia, as the middle class continues to grow.