Person to person loans have been around since money was invented -- and well before banks were. They occur when a private individual lends some money to another private individual, and often additionally involve the payment of interest. Of course, in plain English, one of these is a form of "personal loan," but in financial jargon that phrase has come to mean something different: A personal loan is when someone borrows from a bank or other professional lender, but isn't required to put up collateral, which is something valuable (often a home) that the lender can seize if the borrower fails to make agreed payments or otherwise defaults.
Just to make things more complicated, a new sort of borrowing has emerged over the last few years that combines some of the attributes of both those types of loan. Peer-to-peer (P2P) lending is when a private individual or group of individuals lends to another private individual (or sometimes a small businesses) via a web-based lending platform. But that's a whole different story.
Person to person and personal borrowing generally share some characteristics: they're typically quick, cheap (or free), and easy to set up. But how do the two differ, and which is better in what circumstances?
Person to Person Loans
Imagine Jo, a widow in her late 70s whose savings are earning her roughly 0.3 percent. Then imagine her daughter Jilly, who wants to remodel her kitchen. Jilly has a good job and a great credit score, but would still probably have to pay close to 7 percent annual percentage rate (APR) if she wanted an unsecured personal loan from her bank. Jo could increase her yield four-fold and Jilly could slash her interest payments to one fourth if the two cut out the banks and did a deal directly.
That's a true story: Jo was this writer's mother and Jilly his sister. And the arrangement worked perfectly, leaving both sides very happy. But suppose something had gone wrong: Jilly had become sick, or lost her job, or interest rates had suddenly rocketed back up to 1970s levels. Then Jo might have missed out on some much-needed income, the relationship with her daughter might have soured and there could have been serious family ructions as siblings took sides.
Other problems can arise with person to person loans. Sometimes, memories fade about the amounts that have been borrowed and repaid, the interest rates (if any) that were agreed and the whole nature of the arrangement: "You mean it was a loan? I thought it was a gift." That's why most financial experts suggest at the very least keeping track of payments, and drawing up -- no matter how loving the relationship -- a "promissory note" that states how much was borrowed, any interest that is going to be charged and the agreed repayment schedule. If the amount involved is large, it may be worth having an attorney write something more formal.
By the way, if the loan is interest-free, the IRS might want to treat the amount saved as a gift for tax purposes ("impute" the interest). That's fine, providing it doesn't bust the annual cap on your gift tax exclusion, but needs to be taken into account if it does. If interest is going to be charged at a high rate (anything over 10 percent), you should check your state's usury laws to make sure the agreement's legal, according to NOLO, a legal advice website.
Borrowing from a bank may usually be more expensive than getting a loan from family or friends, but it does mean you're not putting at risk some of the most important relationships in your life. And for many that's a price worth paying, especially as personal loans are very affordable (as low for people with great credit as 6.7 percent APR at the time of writing) compared with many other forms of borrowing, especially credit cards.
Homeowners can usually borrow at even lower rates using home equity products, but these require you to put up your home as security. They also tend to take much more time, hassle, and expense to set up. Getting approved for a personal loan can sometimes take a matter of minutes, and some lenders even offer existing customers same-day access to funds. However, it's important to shop around so you can compare rates and any fees: there are some excellent deals out there. While you're online, make sure you understand the triggers and levels of any penalty rates and fees.
Which Should You Choose?
If your credit's shot, you may have no choice other than to opt for person to person loans. Chances are a bank's going to decline your application, or at least charge you an extortionate interest rate. If you're in a strong financial position, you may also choose this route. Like Jilly, you can be confident you're going to make all payments as agreed, and you won't be putting any of the most important relationships in your life at stake.
If you're somewhere on the spectrum between those two extremes, you need to do some serious risk/benefit analysis: How much are you going to save financially? How likely is it you're going to fail to repay the debt to the lender's satisfaction? How easily are you going to live with any damage you do to the bonds you have with close family and friends? It's a tough decision.