It’s amazing how the Internet, over the past two decades, has changed the way we do so many things, such as, pay bills online, open bank accounts, transfer money to and from, trade stocks and mutual funds, and many other very convenient things.
However, until a few years ago, if you wanted to borrow money, your choices were limited. Even though you can now apply online, what if you were turned down for a loan from a bank or finance company? Family and friends were usually your last choice for funding.
Enter peer-to-peer lending (aka social or P2P lending). Today, as a by-product of the Internet and the social web, peer-to-peer lending has filled a market niche in a very interesting and viable way.
Companies have set up business online as a way to assist P2P lending that works outside of traditional lending. This type of lending typically connects individual borrowers with a group of individual lenders to arrange small, short-term loans.
The economic crisis and stringent loan criteria of financial institutions today has led to further development of this market. Credit can be obtained via P2P lending much easier and without such tight restrictions.
And the trend is growing.
Borrowers seeking to consolidate debt or obtain business startup (or growth) funds have turned to P2P lending sites, particularly because the red tape and high interest rates for traditional loans has become a barrier for the many.
It’s important to note that peer-to-peer lending is generally a for-profit activity, not a charity or person-to-person philanthropy or crowd-funding.
Based on several criteria (credit score, debt-to-income ratio, size of loan) a borrower is given a rating which in turn determines an interest rate. Once approved, the borrower’s information is added to the site for potential investors to loan them the money and collect the interest. (No sensitive information is shared publicly.)
For lenders, investing in these loans is similar to investing in bonds. However there are potential risks and a downside for them. Borrowers can default on the loan and lenders may have no legal way to pursue borrowers who default. However, two years ago, regulators required the sites to stop issuing notes to lenders unless they were registered with the Securities and Exchange Commission. This has cut the default rate below 3%, which is slightly above bank and credit card default rates.
Lenders (or investors) can chip in anywhere from $25 to $1,000 toward a loan until the amount of the loan is reached and paid out. Borrowers pay a fee for the service that connects them to the lenders.
Websites like LendingClub.com and Prosper.com (in the U.S.) and Zopa.com (in the U.K.) bring together a large network of borrowers and investors.
The whole point of P2P lending is so borrowers, small and large, can get better interest rates and investors (also small and large) receive better returns than the nominal rates returned on savings accounts.