The core business of a bank is to gather up funds from investors to lend to borrowers.
By charging borrowers a higher rate of interest than is paid to investors, the bank makes a margin which covers its costs and provides a healthy profit for its shareholders.
The concept of peer-to-peer lending is to provide a marketplace where investors and borrowers can get together directly.
That way, it is possible for investors to earn a higher rate of interest than a bank will offer and for borrowers to pay a lower rate of interest.
In theory it is a win-win for investors and borrowers.
Peer-to-peer lending services must be licensed by the Financial Markets Authority and follow certain regulatory requirements.
The service is usually provided on a website and operates as a kind of matching system.
Borrowers complete an application form online stating the amount and purpose of the requested loan. They must also provide personal financial information.
The peer-to-peer lending service performs a credit check and assigns a credit rating to the borrower. Approved borrowers are listed anonymously on the website and investors can then select borrowers to lend to.
The investor's funds can be split among several borrowers so as to reduce risk.
Funds are repaid by borrowers directly into the investor's account.
For borrowers, the key issue to consider is the fees that are charged, especially in the event that the borrower is not able to keep up the repayments. Investors pay a management fee to the service provider and must consider the risk of not being repaid their capital or the interest owing and the risk that they may not be able to cash in their investment before the maturity date of the loan.
-Liz Koh is an authorised financial adviser.
The advice given here is general and does not constitute specific advice to any person. A disclosure statement can be obtained free by calling 0800 273 847. For free e-books see moneymax.co.nz and moneymaxcoach.com