How peer-to-peer loans affect your credit

neyro2008/iStock/Getty Images

neyro2008/iStock/Getty Images

Peer-to-peer loans (offered on sites like Lending Club and Prosper) have become a popular alternative to traditional forms of credit from big banks.

Because everything is handled online and the lenders are voluntary investors, P2P loans often require lower operating expenses, translating into lower interest rates compared with loans and cards from traditional banks.

If you’re used to credit cards, however, it’s important to understand how P2P loans can affect your credit differently.

Comparing and applying

The research and application process is the most notable difference between cards and P2P loans. When you apply for a card, you take a leap of faith: You won’t know your limit or APR until you’re approved. In fact, there’s no guarantee you’ll be approved. Because applying requires a hard pull of your credit report, the process alone can ding your credit.

With P2P loans, the process can vary. Not all P2P loan sites operate the same way, but for two of the biggest (Prosper and Lending Club), potential borrowers visit the lending site and enter the amount they need. At that point, a soft credit pull (meaning no credit damage) is performed, and applicants will see whether they qualify for the loan (P2P sites each have their own approval standards) and what the interest rate will be.

“Then, if they want to go ahead and actually get the loan, a hard-pull inquiry is done,” says Stu Lustman, founder of P2P Lending Expert, a blog that chronicles Lustman’s own experiences as a P2P loan investor.

The upshot? Comparing P2P loans can be easier than comparing cards.

“That’s one of the benefits because you can shop around for the best rate, the best online lender and you don’t have to worry about your credit score,” says Ryan Lichtenwald, who writes for Lend Academy, which covers the P2P lending industry.

You can replicate this soft-pull-preapproval process somewhat when shopping for credit cards by waiting for pre-approved offers in the mail. Or you can make use of the several soft-pull card-comparison tools out there.

By the way, the investors (who fund these loans) will see some information about you and your credit when you apply, although nothing that will personally identify you. We’re talking things like your revolving credit utilization, reason for applying, credit score range, delinquencies, income and partial ZIP code. Lichtenwald provided the screen shot below to show the various things investors have to consider:

p2p application what investors see

How P2P loans can help your credit

The loan itself – and how you treat it – can have potentially positive effects on your credit life:

Credit variety
Credit mix” makes up 10 percent of your FICO score. You’ll be rewarded if you have a variety of credit types – ie, a mix of revolving (credit card) accounts and installment accounts (term loans). P2P loans fall under the “term loan” category, Lustman says. So if you have nothing but cards on your report and get a P2P loan, your credit variety increases, and your score could get a small boost.

Credit utilization
The majority of P2P loan applicants, Lustman and Lichtenwald say, are using these loans to consolidate credit card debt.

That can have big implications for the “amounts owed” section of your FICO score, which accounts for 30 percent of your score. FICO’s algorithms compare the amount of revolving credit you have (ie, the credit limits across all your credit cards) to how much you’re using (your balances). If you’re eating up most of your total revolving limit, your score gets weighed down. If you reduce that revolving debt-to-credit ratio, your score will get a lift. Term loans (such as P2P loans) are not factored into this revolving-utilization calculation, so shifting debt to a P2P loan can lower your utilization and boost your score.

For example, say you have two cards with a total credit limit of $25,000 – and balances totaling $20,000. That’s a rather high (FICO-damaging) revolving utilization of 80 percent.

“If you get a $20,000 installment loan and move the debt over, you’re freeing up your revolving credit, and your revolving utilization goes way down,” Lustman says.

Faster pay-off
While it won’t have a direct effect on your score, the interest rate you get on your P2P loan could accelerate your debt pay-off, which can help you keep your credit healthy in the long term.

Credit cards, especially rewards cards, tend to have interest rates of more than 15 percent.

“But if you have a really good credit score and you’re determined to pay off your credit cards, what you can do is apply for a loan at Lending Club or Prosper and usually get a rate that’s considerably lower,” Lichtenwald says. “It’s a really good product for people looking to consolidate their credit at a more attractive rate.”

How P2P loans can hurt your credit

When you apply for a P2P loan, the hard inquiry will temporarily damage your score. That’s out of your control. What is in your control, however, is how you treat the loan over its life – and peer-to-peer loans, like any other type of credit, can harm your score if you do the following:

You use your P2P loan to raise your revolving utilization again
Ideally, you’d use your P2P loan as described above to take the weight off your cards.

“What ends up happening with a lot of Americans, though, is they start using the cards again and that can make things worse,” Lustman says.

If you run up your cards again, your utilization shoots back up – and now you have a heavy debt load of revolving and installment credit, which is not attractive to lenders.

“If you take out the loan and continue to rack up the card debt, it becomes a cycle,” Lichtenwald says. “And certainly, your score isn’t going to improve.”

So if debt consolidation is your goal, consider doing what a friend of Lustman’s did – cut up your cards so you can’t use them after you get the P2P loan. Or freeze them in a dish of water and keep them in the freezer.

You pay late
If you pay more than one billing cycle late, that late payment will end up on your credit report and become a hit to your credit score. If you continue to be late, your P2P loan (just like any other form of credit) could end up in collections, an even bigger hit to your score.

And because P2P loans are installment loans, it may be easier to become delinquent than it would be with a credit card.

“Because it’s an installment debt, when you get into trouble, you can’t do what you’d do on the credit card, which is just pay the minimum,” Lustman says. “If your terms require you to pay $250 a month over 60 months, that’s the deal and you have to pay that. Otherwise, you’re talking about collections and defaults.”

The bottom line

If you have the discipline and can budget for the monthly payments, P2P loans can help you aggressively pay down card debt– and even have some credit-lifting effects. Because seeing what you qualify for requires only a soft credit pull, there’s no harm in shopping around. Just be sure to compare the overall costs and benefits to other methods of rapid debt pay-off, including balance transfer cards.

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