Peer-to-Peer Lending

    For peer-to-peer lenders, the Great Recession was manna from heaven. When banks clamped down on lending to all but their best-heeled customers after the 2008 global economic meltdown, fledgling peer-to-peer online loan sites rushed to meet the nation’s need for credit and cash.

    In less than a decade, peer-to-peer lending sites have become a go-to source for those willing to wander beyond the confines of conventional finance. The online lenders, often called P2P businesses, charge a fee to connect investors with ready cash and loan customers, many seeking unsecured personal loans.

    Qualified P2P borrowers typically pay lower interest rates than banks advertise, while investors enjoy returns they might not earn elsewhere. The process amounts to a virtual environment of opportunity, in which people can borrow and lend on a more personal basis.

    Peer-to-peer lending, a form of unsecured debt, debuted in the mid-2000s and took off during the economic downturn a few years later. In the beginning, members of ethnic and social groups formed borrowing pools, playing on the common bonds that the group members shared. Today, P2P lending is global and increasingly is transacted through facilitator websites. Two of the biggest names in the field, the middleman websites Lending Club and Prosper, service hundreds of millions of dollars in loans.

    As this type of lending has evolved, the lending groups have become less restrictive, enabling more lenders and borrowers to participate. Borrowers receive the capital they need, while the lenders get a greater return on their money than they would if it sat stagnant in their personal accounts. In recent years, checks and balances have been put into place to make peer-to-peer lending even more accessible.

    Types of Peer-to-Peer Loans

    P2P loans are generally $35,000 or less, but collectively add up to billions of dollars. There are three main types of P2P loans available.

    Personal Loans

    Borrowers use the loans to finance medical bills, automobile purchases and home improvements. They can also cover debt consolidation. These loans are often easier to get through social lending groups because they don’t carry the same restrictions as those from financial institutions.

    Business Loans

    These loans can cover start-up costs such as marketing, facility maintenance and repair or new-product launch expenses. Social lending groups are an attractive source for business loans because borrowers can present their loan proposals to multiple lenders, increasing their chances for approval.

    Student/Educational Loans

    These are typically lump-sum loans, which gives the borrower discretion on how to divvy up the money for school-related expenses. Although it is best to exhaust federal student aid options before considering alternative loans, social lending groups can offer competitive rates for student loans.

    State Restrictions

    Although peer-to-peer loans are often made across state lines, not all P2P platforms are available in all locales. For instance, Lending Club loans aren’t available in Iowa and Idaho. Prosper loans can’t be made to residents in Iowa, Maine and North Dakota. But options are available in all states except Iowa. Search the websites of major P2P lenders for details.

    How Social Lending Sites Work

    Social lending websites have a strong presence on the Internet. Borrowers should check the consumer reviews and ratings for each site, and always read the fine print. A reputable site usually will not charge a fee for joining or making a loan request.

    The typical process has several steps:
    1. Borrower signs up for an account– This is usually free and requires personal and financial information so the website’s platforms can pull credit history, proof of income and other information related to the loan.
    2. Borrower makes a loan request – This is where the borrower has much more freedom than with a traditional bank because there is opportunity to sell the deal to potential lenders. Borrowers get to tell their story — what they are asking for, why they need it and any related information that might make them more appealing to lenders.
    3. Lenders consider the request – This process can be compared to the bidding environment on eBay. Lenders see an investment opportunity in which their disposable income can earn them a certain return. Sometimes one lender will fund all of a loan, while other times several lenders will pool their money — particularly if the borrower is considered higher risk.
    4. The deal is closed – Once the lender or lenders agree to loan the money, the deal is closed and the parties sign off on terms. The website will monitor the loan over its life, collect the monthly payments, and distribute that money to the lender or lenders.

    Qualifying for P2P Loans

    Lending services such as Prosper and Lending Club require completion of online applications. They use the information to check credit scores and qualify borrowers. They also consider the length and amount of a loan to determine interest rates. Then they place the proposed loan on a lending platform for consumer lenders to study. If a borrower and lender click, the loan is executed. Peer-to-peer loans are personal loans, ranging from $1,000 to $35,000 for individuals and $15,000 to $100,000 for businesses. The loans often come with three- or five-year terms and monthly payments.

    Facilitators typically charge origination fees of 1% to 5%, depending on the size of the loan. Interest rates vary. Lending Club reports its interest rates averaged 12.6% in the last quarter of 2015. Annual interest rates vary from less than 6% to about 36%.

    Qualifying credit scores vary, but a credit score greater than 600 is generally required. As with other personal loans, the better one’s score, the more favorable the loan term should be.

    Late payments are also costly, with sites charging $15 or more when payments are more than 15 days overdue.

    Borrowing Tips

    There are some basic tips every potential borrower can follow to ensure they get the loan they’re after.

    • Be Honest with Yourself – Look at yourself the way a lender does. You need to convince the lender that you’re the kind of person who will repay a loan, so provide evidence and stress your creditworthiness.
    • Be Honest with the Lender – Never be misleading or lie. Word travels in the online lending community, so don’t build a reputation for dishonesty. If you’ve had financial or credit problems in the past, come clean. It’s better to be forthcoming than be caught being deceitful.
    • Lay out Your Case – Explain clearly what you plan to do with the money. Specifically say how the proceeds will be used, avoiding vague statements. Lenders don’t like vagueness.
    • Neatness Counts – Proofread your application, getting the grammar and spelling right. Nothing says scatterbrained or scammer like a sloppy, hastily-drafted application. Lenders need to trust you, and they want to trust their money to a conscientious borrower.
    • Don’t Overshoot – Lenders will consider your debt-to-income ratio before they hand you a loan. If your application doesn’t show an income stream or a credit history that is conducive to repayment, it’s unlikely you’ll get what you asked for. Remember, make realistic requests.

    Pros and Cons of P2P Lending

    Like most things, there are advantages and disadvantages to using peer-to-peer lending.

    The Pros

    P2P loans can be used for just about anything, substituting for second mortgages, home equity credit lines or traditional bank loans. They commonly require a lot less paperwork than bank loans and the fees and interest rates are lower, a plus for borrowers. Lenders can also benefit because the loans yield returns that surpass bank or bond interest. Returns can be even higher if lenders make the loans themselves and avoid fees from facilitator websites.

    The Cons

    Lenders can suffer a loss if loans aren’t repaid. They also have to manage the collection process in a default unless they use a facilitator company or a collection agency, both of which charge fees. Those interested in lending should consider all the options and consider making a number of small loans rather than fewer big ones. In most cases, spreading the risk across a larger number of buyers limits potential losses. Working out the details with a financial advisor is a good idea.

    The Future of Social Lending

    Consumers are always looking for quicker and more convenient ways of borrowing money, so peer-to-peer lending appeals to many borrowers who may not want to deal with the paperwork and processing time required when dealing with conventional financial institutions.

    Peer-to-peer loans are 70% cheaper than what you would pay using credit cards, which also makes them increasingly attractive. Another new site, SoFi, is offering similar discounts on student loans.

    According to Bloomberg Business News, the worldwide volume for P2P lending was expected to reach $77 billion in 2016, or 15 times more than was lent in 2012. In the United States, peer-to-peer lenders generated $6.6 billion in loans in 2014, an increase of 128%. Expectations are the U.S. market will continue to grow and reach $150 billion over the next 10 years.

    Default rates for Lending Club and Prosper are below 3%. That has investors pouring money into peer-to-peer lending sites, another sign this is a viable business model.

    Economic uncertainty remains an issue for social lending, however. Concern about defaults and the trustworthiness of borrowers is cause for concern.

    Bill Fay

    Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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