Crowdlending

What is crowdlending?

Crowdlending refers to loans for funding companies or individuals, which is consequently categorized as borrowed capital. Crowd lending is also known as peer-to-peer (P2P) or social lending because funding is provided by individuals or companies that are not financial institutions or financial intermediaries8. Referring to the distinguishing criterion mentioned above to differentiate sub-types of crowd funding, participants (funding providers) receive a payment in return for their funding made available to the project developer (borrower), typically in the form of interest, and although participating loans9 or bonds / notes issuances are also possible. The amount of the interest or return payment varies depending on the risk of the project and borrower, but typically represents a lower interest charge for the borrower that traditional bank lending.

Crowdlending exists in various forms and uses diverse business models, depending on the legal, regulatory and tax requirements applicable to the chosen form; however, it invariably involves three main actors:

  • The platform operator or the platform, referring to the manager of the crowd funding online platform on which projects are published and through which the project developers and the participants (backers) can connect
  • The participants or funding providers, referring to the individuals or companies providing funding, and
  • The project developer or funding recipient, referring to the individual or company seeking to rise funding for a particular project or purpose.

From a contractual perspective, there will exist bi-lateral contractual relationships as between each pair of involved parties (i.e., between each participant and the platformoperator, between the platform operator and the project developer and, most importantly,between each participant and the project developer). The characteristics and legal classification of such contractual relationships will depend on the business model and the specifics of each transaction.

Typically, from a contractual viewpoint, the relationship between the project developer and the participants / funding providers will usually be characterized as a loan within the meaning of Articles 305 ff. of the Swiss Code of Obligations (SCO). In some circumstances, however, the funding may be packaged into securities (bonds or notes) issued by the project developer; in other situations, the contractual relationship can be characterized as a consumer credit, which is regulated under the Swiss Consumer Credit Act. The characterization of the relationship may trigger various legal and regulatory obligations for each of the parties involved, as we will see below.

Finally, in the context of crowdlending, the platform often plays a more active role, managing the funding, collection of principal and interest payments and thus handling financial assets on behalf of others, something which typically triggers the application of financial regulations.

Peer-to-peer lending is a subpart of crowdlending, because you can also make crowdlending with enterprise.

Characteristics

Crowd lending does not fit cleanly into any of the three traditional types of financial institutions—deposit takers, investors, insurers—and is sometimes categorized as an alternative financial service. Typical characteristics of crowdlending are:

  • It is sometimes conducted for profit;
  • No necessary common bond or prior relationship between lenders and borrowers
  • Intermediation by a peer-to-peer lending company
  • Transactions take place online
  • Lenders may often choose which borrowers to invest in, if the crowdlending platform offers that facility.
  • The loans can be unsecured or secured and are not normally protected by government insurance but there can be protection funds like those offered by Zopa and RateSetter in the UK.
  • Loans are securities that can be transferred to others, either for debt collection or profit, though not all Crowdlending platforms provide transfer facilities or free pricing choices and costs can be very high, tens of percent of the amount sold, or nil.

Early peer-to-peer lending was also characterized by disintermediation and reliance on social networks but these features have started to disappear. While it is still true that the emergence of internet and e-commerce makes it possible to do away with traditional financial intermediaries and that people may be less likely to default to the members of their own social communities, the emergence of new intermediaries has proven to be time and cost saving. Extending crowdsourcing to unfamiliar lenders and borrowers opens up new opportunities.

 

Most peer-to-peer intermediaries provide the following services:

  • Online investment platform to enable borrowers to attract lenders and investors to identify and purchase loans that meet their investment criteria
  • Development of credit models for loan approvals and pricing
  • Verifying borrower identity, bank account, employment and income
  • Performing borrower credit checks and filtering out the unqualified borrowers
  • Processing payments from borrowers and forwarding those payments to the lenders who invested in the loan
  • Servicing loans, providing customer service to borrowers and attempting to collect payments from borrowers who are delinquent or in default
  • Legal compliance and reporting
  • Finding new lenders and borrowers (marketing).

Who invests in crowdlending?

Crowdlending loans may be funded by an individual investor or a group of investors. According to MarketWatch, crowdlending loans can be a good way to diversify the portfolio of income investors who take time to understand the risks and rewards. Income investing generates a cash income in the form of dividends and interest. In other words, investors don’t buy a stock, bond, or other investment and wait for it to appreciate in value so they can sell it and earn a profit. Simply holding on to the investment generates income.

Crowdlending loans are an income investment because once an investor opens an account and choose to participate in a loan, principal and interest payments (fewer fees charged by the platform) are deposited into the investor’s account on a monthly basis.

The investors may be individuals or institutions, such as banks, pension plans, foundations, finance companies, asset managers, insurance companies, broker-dealers, and hedge funds. Individual investors can open an account with Lending Club with an initial investment of $1,000, but other platforms are available only to institutions and accredited investors (those who can demonstrate high-earned income and net worth).

Connor Murphy, a public relations and communications specialist with Funding Circle, says their platform in the U.S. is only open to accredited investors and institutional investors. “We actually use the term ‘marketplace lending’ rather than peer-to-peer lending,” Murphy said, “because investors on our platform globally include large financial institutions and even governments.”

Whether the investor is an individual with $1,000 or an institution looking to invest $250,000, they select loans to invest in and earn monthly returns on. According to Sarah Cain, head of communications at Prosper, borrowers do not know their lenders. “They simply know if their loan has been funded or not,” Cain said.

Why using crowdlending?

P2P lending platforms started gaining traction more than a decade ago as a way to bypass banks and use technology to connect investors with money to the borrowers that need it. P2P lenders have claimed their online platforms help them reduce costs, and that, in conjunction with analytics and proprietary algorithms, allow them to offer borrowers lower interest rates or provide loans to individuals who have been refused loans by traditional banks.

 

LendingClub currently advertises APRs for personal loans from 5.99 percent to 35.89 percent. The company surveyed borrowers during the first seven months of 2017 and found that borrowers who received a loan to consolidate existing debt or pay off credit card balances reported that they saved an average of $287 per month. However, that statistic compares high-interest credit card rates with personal loan rates – not P2P personal loan rates to bank personal loan rates.

As of August 2017, the average APR on credit cards carrying a balance was 14.89 percent, but banks may offer much lower rates for personal loans. Of course, whether you choose a P2P loan or a bank loan, having a high credit score can help you get the lowest rate offers, while a lower credit score will likely stick you with higher interest rates, if you are approved for a loan at all.

Some borrowers just prefer the idea of avoiding large, traditional banks. But as with any borrowing decision, you should compare apples to apples when seeking financing for any purpose and shop around for the best rate.

Applying for a peer-to-peer loan

To apply for a loan, a potential borrower visits a crowdlending lending website and fills out an application.

The platform leverages online data and technology to assess risk, determine a credit rating and assign an appropriate interest rate. Applicants may receive offers within a few minutes and can evaluate options without impacting their credit score. Once you select a loan offer, you’re required to complete an online application that gathers information about your income and employment as well as identifying information, such as address and Social Security Number.

You may also be required to provide additional documentation to verify your identity, income, and employment. That may include:

  • Tax forms such as W-2s and 1099s
  • Tax returns
  • IRS Form 4506-T, which is used to request a copy of your tax forms or returns directly from the IRS
  • Recent bank statements or pay stubs
  • Proof of income from alimony or child support, pension or annuity income, disability insurance or workers compensation benefits, if applicable
  • Copies of government-issued photo ID
  • Utility bills

Once you’ve completed the application and submitted the necessary documents, your application is reviewed and the platform matches you with investors to fund the loan. Once the loan is approved, the funds are deposited into your bank account. The process can take anywhere from seven to 45 days.

Each P2P site has its own rules and approval criteria, including minimum credit score, so an application declined by one platform doesn’t necessarily mean that you won’t be approved by the others.

The Financial Industry Regulatory Agency (FINRA) reported that P2P lenders tend to be more forgiving than banks when it comes to short credit histories, but if you’re trying to get a P2P loan with less than stellar credit, don’t expect the lowest rates.

Lending Club states that applicants who qualify for the lowest rates have:

  • An excellent credit score
  • A low percentage of total outstanding debt compared with income
  • A long history of credit with significant successful credit lines.

What are the advantages and risks of crowdlending?

The most important advantages for borrowers:

  • The process is (usually) more transparent, easier and quicker than with a bank
  • It provides an opportunity to enter into direct contact with potential customers and receive direct feedback.

The most important advantages for investors:

  • Comparatively attractive return opportunities
  • Easy to achieve risk diversification thanks to low minimum investments.
  • Overall management of the loan arrangement (credit check, documentation, payment processing and collection) is carried out by the market place operator

As with all forms of investment and financing, crowdlending also involves certain risks. If the borrower defaults, the investor is threatened, in a worst-case scenario, with the loss of his or her entire investment. Investors should also bear in mind that borrowers may be late in meeting their payment obligations in certain circumstances or that they may wish to pay off the loan early if possible. Credit seekers, on the other hand, should be aware that the rejection rate for loan applications is high and that a poor credit rating can lead to high interest payments. What is more, they are assessed by both the crowdlending providers and the lenders, which can entail long waiting periods.

What are the disadvantages in comparison with personal loans?

Crowdlending has a number of crucial disadvantages for borrowers in comparison with traditional personal loans. With personal loans, for example, it is clear relatively quickly what the amount of the loan will be. In the case of crowdlending, however, it is possible that not enough investors will be found and a loan will be paid out very late or not at all. This can make crowdlending a slow process, even though speed is normally one of its advantages.

A further major drawback of crowdlending in comparison with personal loans is the lack of borrower protection. Unlike personal loans, loans via crowdlending platforms are not governed by the Consumer Credit Act because they are issued from person to person. This act forms the basis of regular loan agreements, however, and is intended to protect borrowers from getting into too much debt. As a result, the result of the risk assessment is often worse than with banks. Furthermore, the amounts of money involved are often small in comparison with classic personal loans. This makes it difficult to diversify risk, with the result that even minor defaults can have a major impact.

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