How peer to peer lending works

Peer to peer lending is a fairly new form of alternative finance.  Today we’re going back to basics to explain the mechanics behind people to business funding.


April was financial literacy month – or at least it was in the US, where financial literacy tests like this one from the Huffington Post were popping up everywhere.

Here in the UK we may not have a national reason to focus on financial education, but, just like in the US, there is a very real need to improve our collective understanding of how the banking system works, get to grips with the options that exist to help us manage our money well and generally improve financial decision making.

So, today, the FundingKnight blog is going back to basics and looking at just what peer to peer lending really is.

Put simply, it’s is a way for people to lend to each other – or businesses – without using the mainstream banking system to act as a middleman.  Removing that step in the process typically helps to reduce costs and so, often, peer to peer lending can deliver better rates for borrowers and better rates for lenders.

It is also a whole lot simpler than lending and borrowing through a bank and the fees and charges are more transparent on both sides of the lender / borrower transaction.

Why does peer to peer lending often offer good value? Why can it offer more transparency?

One answer to both questions is the small matter of spread, which brings us neatly back to where we began with financial literacy.

A spread is the difference between what a borrower pays and what the lender, or lenders, receive.

To visualise a simplified version of how the current UK banking system works, take a look at the diagram below:

diagram showing that interest rate spread is the difference between what a borrower pays and a lender receives

In this scenario, the bank takes a spread of 7%.

In reality, the actual spread taken by high street banks can be much larger. Towards the end of 2011, for example, peer to peer lender Zopa carried out research based on Moneyfacts data that showed that a typical Bank Spread was actually 11%.

What’s more, Zopa’s survey, carried out by Ipsos Mori, revealed that “93% of UK consumers aged 18 or over do not know what a ‘bank spread’ is and that even amongst those who thought they did know, less than half actually did.”

Unsurprisingly, many of the participants thought that a spread of 11% was rather high once the concept had been explained.

When it comes to P2PLending, things are a little bit more straightforward.  Here’s a diagram of how a marketplace run by a peer to peer lending service – such as Zopa for people to people lending or FundingKnight for people to business lending – might work:

diagram showing that peer to peer lending relies on transparent fees rather than taking a spread

In this case, both the borrower and lenders pay a fee that is clearly set out at the start and visible to both sides of the deal. Once that’s agreed to, interest passes directly from the borrower to the lenders that collectively get together to make up that loan.

The peer to peer lending service doesn’t take a spread and all of the interest rates that people pay or receive are transparent and freely available.

Of course, there are other issues to consider.  Peer to peer lending is not covered by FSA regulations and lending to others does raise the possibility of what would happen if they don’t repay their loan.

This is something good peer to peer lending services work hard to address, through rigorous credit checking, industry standard fraud checks and by encouraging lenders to spread their money amongst as many borrowers as possible to ‘spread their risk’.

Like everything, peer to peer lending is a personal choice that might be right for some and not for others, but when it comes to financial literacy, we think simplification and transparent fees and charges have got to be good news.

Photo credit – Used under Creative Commons Licence