Peer-to-Peer Lending: The Next Big Dot-Com Boom?

Over the last several years, the idea of "peer-to-peer" services on the internet has grown significantly. Record companies filed lawsuits when Napster allowed computer users to share songs with one another. Many theatrical films are now preceeded by a reminder that "Dowloading movies is stealing." The impact of peer-to-peer networking is clear: the ability to share information freely across the internet threatens to make the "corporate middleman" obsolete.

Now, a new concept is gaining momentum on the internet. Peer-to-peer banking. Internet users are coming together to lend money to one another, without using the traditional banking system. Whereas movie and music file-swappers are simply exchanging entertainment, some enterprising computer users are exchanging money.

A new company called Prosper.com may very well become the same type of threat to traditional banks that Napster was to the music industry, before it was re-launched in association with the recording artists. On Prosper, lenders and borrowers come together in an atmosphere free of the pressure and regulations that make obtaining a traditional loan so intimidating.

Most borrowers on Prosper have less-than-spectacular credit, and, in many cases, probably wouldn't be able to obtain a loan from a traditional bank. But on Prosper, they will find lenders willing to take a risk, in exchange for a considerably high interest rate.

Many lenders on Prosper are just average people, not bankers. They have a few hundred dollars they'd like to invest, but they want a better rate of return than a CD or savings account would offer, without the risk of the stock market. On Prosper, lenders have a reasonable expectation of receiving 8, 10, or, in some cases, as high as 35% return on their investments in interest payments. And if a borrower should default on the loan, Prosper's collection agency, not the lender, handles the collection calls. Another advantage is that a lender can make several small loans, thus limiting his overall risk. For example, ten $100 loans at 5% carry less risk than a single $1000 loan at 5%, because it is highly unlikely that all ten borrowers would default.

The site follows the Ebay model in that the "community" basically polices itself to avoid fraud. First-time borrowers are encouraged to join groups of similar borrowers. If a group member fails to make a payment on a loan, usually it is the group leader who will make first contact with the borrower, gently reminding him or her that any failure to pay up will reflect badly on the group. Sure, it's little more than peer pressure, but it seems to work.

The actual process of obtaining a loan has similarities to the Ebay model as well. Say, for example, you need to borrow $1000 to build a new deck. You post your request for a loan, and lenders place "bids" on your request. In the bid, the lender will state how much they're willing to loan you, and at what interest rate, based upon your credit rating. Prosper then takes the best offers that meet your requirements and combines them into a single loan. So, for example, if you had one lender offering $500 at 7%, and one lender offering $500 at 5%, you would receive a loan of $1000 with a 6% interest rate. As a borrower, you then decide whether to accept the offer or walk away.

As borrowers and lenders flock to Prosper and other peer-to-peer lending sites, one has to wonder how the banking industry will respond, once they realize what's going on. The lending industry, for the most part, is highly regulated, and these web sites don't seem to fit in to the existing laws. That's not to say that they are illegal, but these new sites are raising the question of which laws apply to which lenders. For example, companies like Ditech and Quicken Loans are subject to Federal underwriting laws, even though they do a considerable amount of business on the internet. No doubt the banking industry's lawyers will be quick to point this out when Prosper is inevitably dragged into court, just like the great peer-to-peer organizations before it, such as Napster.

When the recording industry sued Napster and, eventually, some of its users, there was considerable backlash amongst young adults and teenagers who had grown comfortable with the idea of downloading music. Would the same thing happen here if the banking industry goes to court to stop peer-to-peer lending? Where would it end? After all, if I borrow a hundred dollars from my dad, is that not peer-to-peer lending? Should that be regulated by the government?

It will be very interesting to see how this all develops over the next year or two. If peer-to-peer lending is deemed legal, it could certainly blow standardized lending out of the water, at least among the younger, more computer-savvy portion of the population. These sites could very well become the next Ebay, Amazon, or Google. On the other hand, if the banking industry really clamps down on these sites, peer-to-peer lending will be just another internet fad that fades into the sunset.