To fund budding enterprises, entrepreneurs have traditionally been limited to going to a bank, asking parents for a loan or wiping out their savings accounts. Today, thanks in large part to the Internet, entrepreneurs have more ways than ever to secure capital to fund startups, purchase raw materials or pay for executive office suites.

Peer-to-peer loans first came about in Europe, specifically in the United Kingdom where online sites like Seedrs and Crowdcube have been funding artists, business startups and expansions for years. Since 2013 or so, P2P lending platforms have become more popular in the U.S. The reason? The process is easy, and the loans are unsecured meaning you don’t have to put your home up as collateral. And the interest rates are lower than most credit cards.

How do P2P Loans Work?

The concept is pretty simple. Private investors agree to lend money to people they don’t know using an online platform like Lending Club, Prosper or Funding Circle. The lender bids on the loans he or she wants to fund, but doesn’t get to select specifically who his or her money is lent to. This ensures anonymity among lenders and borrowers.

Loans are made up of “slices” of money from many different lenders. That way, lenders can spread risk around while getting a return on their investment. The return can be quite good for many lenders’ investments. While it differs from site to site, returns can reach 10 percent or higher on certain loans, but most range from 5-9 percent.

The online platform checks the potential borrower’s credit score and takes several other factors into consideration before a loan is approved. Factors typically include:

  • Income,
  • Company profitability,
  • Tax compliance,
  • Presence of liens.

Once approved and signatures are secured, the money is generally made available to the borrower within two weeks.

What are the Terms of P2P Loans?

Most P2P companies offer loans between $2,000 and $35,000. Though the loans are unsecured, they usually come at a lower interest rate than credit cards. Highly qualified borrowers can expect rates around 6 percent. Some loans have a much higher interest rate of more than 30 percent. The average loan at one leading P2P company is $13,000 at a 13.9 percent interest rate.

Payback periods range from one to five years, and payments are made via the online platform. Payments are reported to credit bureaus so borrowers get credit for repaying the loan according to the terms.

What are Pitfalls of P2P Loans?

P2P loans won’t work for everyone. People with bad credit probably won’t qualify for a P2P loan. The companies that provide these platforms must ensure that lenders get a good return on their investments. Otherwise, the system doesn’t work. That’s why borrowers with less than fair credit (640 or higher), will probably be rejected.

Additionally, states have different regulations regarding P2P lenders, and some forbid them altogether. For example, borrowers can secure loans from Lending Club in every state except Iowa and Idaho. Prosper works for borrowers in 47 states with the exception of Iowa, Maine and North Dakota.

Investors are more limited when it comes to where they can invest. In short, the SEC has legally defined P2P loans as securities, but they’re not part of a national securities exchange like the New York Stock Exchange. Therefore, each lending platform has to apply to each state for access and each state’s regulators look at the lenders differently. Some states welcome this investment opportunity for its residents; others, like Ohio, have yet to approve access.

Entrepreneurs who need cash should consider the P2P market. These loans are a safe, simple, straightforward way for entrepreneurs to pay for start-up costs, expansions or even an executive office suite.

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