Peering Into the Peer-to-Peer Lending Boom
Peer-to-peer lending, or social lending, refers to financial transactions that occur directly between individuals without the involvement of a traditional financial institution. And it's not some passing fad. The Lending Club recently announced it had passed $200 million in total loan originations. Not bad for a business that opened its doors in 2007. And it's just one of many sites such as Kiva.org, Zopa.com, GreenNote.com, and Prosper.com. (DailyFinance writer Alex Salkever reported last month about his experiences as a Prosper.com lender.)
"It Was a Lifesaver"
"I'm not sure what we would have done if we hadn't found Lending Club," says Jenn Waters, who along with her then-fiancée, got a loan of $25,000 in less than two weeks this past summer. "We aren't lazy people that can't pay our bills. We just fell on hard times and had some bad luck, such that we couldn't get a handle on our debt. Plus we had our wedding to pay for in August," says Waters.
The couple tried to get a bank loan, but they had no equity in their condo, so they were forced to look for other options. When Lending Tree pointed them to the Lending Club, they had never heard of peer-to-peer lending. "We did a lot of research before we committed to trying it and spoke to company representatives on multiple occasions. We wanted to know who were dealing with," she adds.
The Waterses will pay off their loan in three years, and the money wasn't cheap: Their loan has a 13% interest rate and monthly payments of $843. However, Jenn Waters says, "It was a lifesaver. Our goal was to be in a much better position a year later, and we are definitely working toward getting there."
Bidding to Borrow, Bidding to Lend
Thanks to the Great Recession, many more Americans have found themselves having to borrow money just to cover the necessities. According to a MetLife (MET) study of the America dream, from 2009 to early 2010, nearly half of Americans said they had given money to a family member so they could pay their bills, and more than a third have had a family member give them money. But family isn't always an option when finances get tight.
Think of P2P lending sort of like a financial version of Amazon (AMZN) or eBay (EBAY), where borrowers and lenders can post their offerings, and each tries to get the best deal they can find, explains Carrie Coghill, director of consumer education for FreeScore.com. "This platform allows borrowers and lenders to choose their own terms and interest rates so that the exchange can work for varying financial needs and wants," she says.
And not all of the loans are between complete strangers. Peer-to-peer lending sites can be used to set up structured loan programs between friends and family members as well.
"If you're really strapped for cash and you might not be able to get a loan through a bank because of a spotty credit history, you may have a better chance of getting one through a lending site, though it will cost more in terms of interest," says Coghill. "If you desperately need money for an emergency, this may be a reasonable option," she adds. "If you have various credit cards that are charging higher interest rates than a P2P loan, you may want to pay off your credit cards and start paying the lower interest."
Chris Larsen, CEO of Prosper.com, rattles off the advantages for borrowers, "Low rates, fixed rated, no hidden fees, a quick and simple process."
Higher Risks, Higher Profits
There are also incentives for the lenders. Investors can earn on average nearly 10% in annualized returns on P2P loans -- higher than CDs or some stocks, says Coghill. P2P companies typically charge a 1% service fee that's subtracted from the interest gained on the loan.
Investor Curtis Arnold has averaged 11% to 13% returns on his P2P loans. "I like being the bank. I'm not a big fan of banks, and this is a way to cut them out of the picture," says the founder of CardRatings.com, which educates people about credit cards. Arnold is also co-author, with Beverly Blair Herzog, of Person-to-Person Lending.
He has loaned thousands of dollars over the last few years, online and offline. While one $40,000 loan was delinquent by four or five months and the terms had to be modified to lower the borrower's payments, his experiences as a lender have mostly been positive. "This is very cool -- a win-win when done right," says Arnold.
"I've been careful not to invest too much while I learned how the system works and what doesn't work," Collett says. For example, in his experience, people who are trying to pay off high-interest credit cards are more likely to pay you back than those who are taking on more debt for things like an addition on their house, starting a business or going to school," he says. And for some borrowers, the experience can be less than rosy.
Great as P2P has been for Collett, he offers these words of wisdom to potential investors. "Some of the information provided on borrowers is more reliable than other information. For instance, credit scores and whether a borrower has been delinquent are harder facts than a borrower's occupation and income because they can be easier to fudge," he says.
Secondly, there is interest rate risk. If you make a 60 month loan at 12% and rates skyrocket to 15% two years down the road, you can lose big. His recommendation: "Mitigate the risk by making a 36-month loan instead."
Hidden Risks of P2P Lending
A couple of other risks don't get much publicity, Collett notes. "You're taking credit risk on sites like Prosper and Lending Club. Lenders are actually getting a note from either Lending Club or Prosper that represents a promise by those companies to pay the lender if the borrower pays them. So if either site goes bankrupt, then that would be a problem."
Also, you're relying on the sites to accurately gather information on borrowers: credit scores, creditworthiness, debt loads, etc. And you'll be counting on them to either pursue any loans that go into default or to sell them off to a collection agency. He says he's known of instances when loans have gone into default and little effort was made to get the lender any money back.
As with investing generally, diversify and spread your risks. "Instead of $10,000 for one loan, make small investments so your money is in many buckets," advises Arnold.
Tips for Borrowers
Those seeking loans would do well, too, not to go blindly into the process. Understand what your credit score is prior to posting your request. You will be "graded" on your ability to repay the loan, says Denise Beeson, who teaches small business management classes at Santa Rosa Junior College in California.
• Provide a Good Reason for Why You're Borrowing. "It is very important that you be clear to the reader what you will use the funds for. Vague or poorly worded applications are sorted out quickly," she adds.
• Get Real. "You've probably been refused by traditional lenders, now you're taking a high-interest loan. You probably can't afford it," says Coghill. Rates can range from 8% to 21%, depending on credit scores. There can also be large late payment fees. They can be 30% of a member loan if a borrower's payment is 60 to 90 days past due.
• Don't Assume Anything. "Lenders on P2P sites are just as capable of hiding terms in the fine print as banks and credit unions," says Coghill.
The peer-to-peer lending genie is out of the bottle, and it's likely only to grow. In fact, "P2P lending is projected to soar to $5 billion in outstanding loans by 2013," says Timothy Burke, CEO of National Family Mortgage, an online resource for families structuring and managing real estate loans with their loved ones. Adds Prosper.com's Larsen: "We're seeing more large investors joining the platform and adding P2P to their portfolios and we see that continuing."
Folks like small-businessman Chris Dagger hope so. The CEO of Custom Confections of Warren, Mass., has used P2P to finance his the expansion of his business. "We have a small three-year loan through Lending Club that allowed us, in just over a year, to grow to three locations," he says. "When it comes to raising finances, I wouldn't do anything but peer-to-peer. The bank is the last place I'd go. I'll happily tell American Express (AXP) what to do with their Platinum Card."