Peer-to-peer lending can be win-win for borrowers and investors

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peer-to-peer-lendingWith banks slamming their doors in the faces of ordinary people who want to borrow money, our peers are starting to take up some of the slack. In this case peers may mean friends, family or even perfect strangers, any of whom can go to a web site and bid on how much they'd like to lend you and what rate they'll charge. Such peer-to-peer lending (PTPL) has grown from $282 million in loans in 2006 to a projected $3.1 billion this year, according to The Washington Post, and estimates suggest it will reach $5.8 billion in 2010. Should you surf the PTPL wave?

Before answering that question, let's discuss how PTPL actually works. One such PTPL service, Lending Club, lets investors pick borrowers -- who must have FICO credit scores of at least 660 out of 850. Investors, who act as lenders, scrutinize the same kinds of details that banks do, such as the borrower's credit score and ratio of debt to income. And they can invest as little as $25 in loans which average $6,000 to a small pool of borrowers at rates between 12 and 13 percent.

Why get involved in PTPL? Ideally, it makes borrowers and lenders better off. Borrowers usually get loans with lower rates than they would from banks or credit card issuers, while investors often get higher returns than they would from traditional bank products such as certificates of deposit. And investors disenchanted by stocks and real estate are betting that PTPL will offer higher rates of return.

Sure, there are risks to investors. Lending Club's borrowers default at a 3 percent rate. Prosper, another PTPL network, has a 5 percent default rate. But those PTPL networks suggest their default rates are lower than those of credit card lenders -- which they claim suffer double-digit default rates.

For borrowers, the challenge is that the repayment period is pretty short -- generally three years. This means that monthly payments are higher. And, just as with bank loans or credit cards, if borrowers miss payments, the sites report them to credit bureaus.

There's also the risk of scams, which is why in 2008, the Securities and Exchange Commission required PTPL companies to register with it. The SEC considers these peer-to-peer loans to be securities.

Should you borrow from peers or from banks? Go with whichever option will give you the best deal. For many, PTPL is the only option available at the moment; but if you can choose between the two, it may be that PTPL will offer you a lower rate.

But if you're an investor, take a hard look at that borrower's real ability to repay -- if someone can't get money from a bank, you risk being suckered by lending to that borrower.

Peter Cohan is a management consultant, Babson professor and author of eight books, includingYou Can't Order Change. Follow him on Twitter. He has no financial interest in the securities mentioned.

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