Would you lend money to a friend? To your brother-in-law? Or to a perfect stranger?
An increasing number of people are answering those questions with a resounding, "Yes!" Over the past three years, lending directly to friends, family members and even total strangers has become a popular way of earning a decent return, while helping out specific people strapped for cash.
Such direct loans are being arranged, executed and serviced through an innovative Web-based model known as peer-to-peer lending.
P2P lending brings together the ideas of social networking and micro-credit, matching people who have money to lend with people searching for a loan. P2P eliminates the middleman — the banking industry — by allowing loans to be made directly from one person to another.
Cutting out the banker creates a "win-win" for the lender and the borrower. The lender earns more interest than can be earned on bank savings, while the borrower pays less interest than would be charged on a bank loan (assuming the borrower could even get a bank loan.)
P2P lenders also get the satisfaction of helping a specific person start a business, pay off higher-interest debt, or remodel a house for a growing family.
The biggest player in the budding P2P industry is Prosper.com, launched in 2006 by Chris Larsen, co-founder and former CEO of E-Loan. Larsen calls Prosper "an eBay for money and credit."
As of July 31, 2009, the site had more than 900,000 members and had helped arrange almost $180 million in P2P loans. (Prosper generates its revenue by charging borrowers an upfront fee and lenders a small percentage of the loan balance.)
But it hasn’t been a smooth ride. Prosper was effectively shut down in late last year after the U.S. Securities and Exchange Commission demanded the company register as a seller of securities. That process took nearly nine months. Finally, with SEC approval, Prosper resumed facilitating P2P loans in July.
Here’s how P2P lending works. Would-be borrowers shop for a loan by posting details (for free) about why they need a loan, how much they want to borrow and what interest rate they're willing to pay. Lenders then bid, offering to fund the loan at the borrower's desired interest rate, or lower.
Usually, loans are funded by pooling money from many individual lenders. A $5,000 loan, for example, might be funded by 100 different people who've each put up $50. Some Prosper lenders have portfolios that consist of hundreds of such "microloans."
The advantage of this micro-credit model is diversification, which greatly reduces a lender's exposure to default risk. In the previous example, if the borrower failed to repay the $5,000 loan, the most any of the 100 lenders could lose is $50.
To help lenders make informed lending decisions, Prosper posts borrower profiles that include a credit score (minimum allowable score is 640), debt-to-income ratio, and information about any current and past delinquencies. The site also assigns each potential borrower a risk rating, ranging from AA (excellent credit) to HR (high-risk).
Borrowers with checkered credit histories can expect interest rates of more than 20%. We don't recommend lending to that class of borrower. Not only is the risk high, but there's also a legitimate question of whether you're really helping someone when charging them such high interest rates.
While lending to high-risk applicants doesn't intrigue us, the lower-risk end of the spectrum does.
In the current low interest-rate environment, the potential of building a 4%-6% micro-loan portfolio (which includes a cushion for a handful of loan defaults) holds some definite appeal. At this lower end of the credit-risk curve, it's also more likely that you're providing legitimate help via lower interest rates than these borrowers would qualify for from traditional lending sources.
Other P2P sites have different procedures and guidelines than Prosper, but the essence of the direct-lending model is the same—people lending to people. Prosper's competition includes LendingClub.com and PertuityDirect.com.
VirginMoney.com, owned by billionaire entrepreneur Richard Branson, focuses on loans between friends and family.
In addition to the default risk noted above, another possible downside to P2P lending is that most loans have a three-year term — with no early-call provision. So if liquidity is a high priority, P2P probably isn't for you. This means you shouldn't use P2P lending services for your “emergency fund” money. But if liquidity isn't an issue, P2P lending could be a good option for an “accumulation” fund.
By making micro-loans to a series of (hopefully) responsible borrowers, you can do well by doing good. While helping yourself to higher returns, you'll be helping others who need access to cash.
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