What is Peer to Peer Lending?

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What is Peer to Peer Lending?

Peer to Peer Lending (also referred to as Person to Person Lending, P2P Lending, or Social Lending), represents an internet enabled shift in the personal loan market place.  The easiest way to explain it is through an example.

Say our friend John wants to remodel his kitchen or payoff his high rate credit cards.  He goes to his local bank branch and applies for a personal loan with a 10% interest rate.  That’s traditional bank borrowing.While loaning funds to John at 10%, the same bank is promoting CD Rates of 1.25%.  That’s traditional bank savings.

Together, the traditional bank is profiting on the 8.75% interest rate spread, which is why the tallest buildings in your nearest downtown area are the bank buildings.

Peer to Peer Lending, as the name suggests removes the expensive bank from the equation and shares the formerly large spread with both the lender and borrower.

Again, consider that now John’s loan is funded at 7% and the lenders earn as much as 6.5% on their ‘savings’ or investment.  John is pleased with the lower rate and the lenders are pleased with their higher yields.

An important note is that many lenders are involved.  John’s loan is not coming from a single person but it’s coming from 10s or even 100s of contributors each ‘investing’ as little as $25 into the full loan.  Think about that, if John has a $10,000 loan there may be as many as 400 individual $25 contributors each participating and profiting from the transaction.

At its core, that’s how Peer to Peer lending works.  Banks are replaced with internet-based brokers or facilitators who lack the cost structure of traditional brick and mortal banks.  For their efforts they participate in the transaction but at a much lower rate.  This enables loans to be made at lower rates and returns to contributors to pay at higher rates.  Everyone Wins!  Right?

 

Benefits of P2P lending

Well, yes. That’s certainly the concept and is mostly the case.  In fact, the Benefits of Peer to Peer Lending are compelling:

  • Lower rates to borrowers
  • Higher rates to lenders than CDs or Savings Accounts
  • Facilitated or brokered transactions
  • Lenders select the loans in which they want to invest (as little as $25)
  • Borrows are screened and tiered for lender review – credit scores, loan purpose, employment record, payment history are all scored to Grade the loan similar to Bond Ratings.
  • Payments to Lenders made monthly, part principle and part interest.  Compare this to long term CDs in which there is often zero access to funds without penalty prior to the full term.
  • There is a secondary market for loans from some P2P brokers, this increases lender liquidity
  • Easy diversification across loans and loan types.

 

 

Risks of P2P lending

In fairness, there are risks related to any type of lending, even traditional banks foreclose on loans on a regular basis.

  • Non-payment.  If a borrower fails to pay, the lender will lose on that individual loan
  • Loan positions are considered investments rather than bank deposits.  They are not covered by FDIC insurance so a lender can lose money.
  • Lender plays a semi-active role in selecting loans and reinvesting their returns as compared a CD which is hands off following initial purchase.

  

P2P Borrowing

As discussed, participating in the P2P market as a borrower is also an option.  In fact, this may be an easier decision to make than lending because your immediate upside is a lower rate, assuming a strong credit rating.

The downside is that your loan may not be accepted.  The leading P2P lenders turn away far more loans than they accept, which is actually a benefit to the lender community.  However, if you carry a strong credit rating and could score a loan from a traditional bank, then you should have no problems.

 

 

Leading P2P Lending sites

Prosper and Lending Club are the leading P2P sites in the US, but there are other entrants into the market.  Here I’ll break down the leading sites.

Prosper


 Launched in 2006, headquartered in San Francisco

$447,000,000 in personal loans funded

Over 1.6 Million Members

1, 3, and 5 year terms

7 Risk Categories with yields ranging between 5.49 and 12.46%

$25 minimum loan contribution

Borrow up to $25,000

Stats as of Feb 2013

 

Lending Club

Launched in 2007, headquartered in San Francisco

$1,348,306,700 in personal loans funded

3 and 5 year terms

7 Risk Categories with yields ranging between 7.54 and 22.57%

$25 Minimum loan contribution

Borrow up to $35,000

Stats as of Feb 2013

 

While there are other emerging participants in this industry, at this time I’d only consider doing business with one of the above companies simply due to their size and duration in the market.  As the new players grow their track record they may become viable alternatives.

 

Is the P2P Market right for you?

As a Borrower, I think the decision is easy.  If you can qualify for a loan with a traditional bank, then why not shop your loan in this market too?  You really have nothing to lose.  I say that with the understanding that I’m not a fan of debt, but if you’ve made the decision to beg a loan from the bank, then you should at least give this a ride.

As a Lender, I think this could be a part of a diversification strategy.  Under no circumstances would I transfer my entire nest egg into this market.  However, if I were feeling frisky I might consider moving a small portion of my emergency fund over for the opportunity for higher yields.  For example, from a 6 month emergency fund you might consider moving .5 – 1 month over.  Similar to my recent stance on Penny Stocks, I would start out by treating this as an entertainment venture and see how it goes.

 

My Experiments with Peer to Peer Lending

I must admit that during my research I’ve become intrigued with the prospect of making a higher return on some of the funds I currently have parked in a low rate savings account.  So stay tuned as I put Prosper and Lending Club to the test.  I’ll document my experience opening the accounts, making my investment selections, and tracking my returns.   

As I document my Prosper and Lending Club experiments the links below will become active, so be sure to check back in.

 

My Lender experience with Lending Club

My Lender experience with Prosper

 

Also, I want to let you know that some of the links above are affiliate links.  That simply means that if you join Prosper or Lending Club from one of my links, I may receive – at no cost to you – a small commission.  If you choose to do this, I’d be very appreciative.

 

Peer to Peer Lending in the News

Below are links to recent news articles on Peer to Peer Lending. These are interesting reading that I recommend checking out.

 

Wiki:  Peer to Peer Lending 

Business Week: Peer to Peer Lending – No Longer Just a Curiosity

Time: Taking a Peek at Peer To Peer Lending

The Economist: Peer Review

CNN Money: Will Lending to a Friend Take Off?

Yahoo Finance:  Peer To Peer Lending: Determining The Future of Banking

Photo:  ganderssen1

Category: Personal Finance, Recommendations

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