What is Peer-to-Peer, Social, and Person-to-Person Lending?

In these tough economic times, it's become harder and harder to qualify for a personal or credit card loan. Of course, payday loans can be obtained, but the interest rates are astronomical (as much as 25%). Even for someone with excellent credit, a loan is hard to obtain, or it carries a high interest rate. What can one do to overcome the effects of the recent credit freeze?

Due to the need for loans and also due to rising loan interest rates, a form of lending, called P2P lending, has grown in popularity. The name P2P stands for peer-to-peer lending, also sometimes referred to as person-to-person lending or social lending. With P2P, lending occurs directly between individuals and without the aid of a financial institution, such as a bank. This is advantageous for a number of reasons:

1. No "middleman". When the middleman (bank) is taken out, transactions are simplified. Loans involve less paperwork and occur much more quickly.

2. Lower interest rate. Because no bank is involved, there are fewer service costs. This translates to lower interest rates.

3. Opportunity to make money. Since P2P lending involves persons, not institutions, private individuals can become lenders and earn significant interest on their money.

Some examples of P2P lending networks include Lending Club, Prosper, and Perpetuity Direct. In 2005, P2P lending stood at $118 million. In 2006, the amount grew to $269 million, and in 2007, $647 million. The total amount of P2P loans is expected to be $5.8 billion by 2010, according to Celent, a Boston-based financial research firm (1).

There are certain borrower qualifications, however, should someone wish to borrow money using P2P lending:

1. FICO score needs to be at least 660, if not higher.

2. Debt to income ratio (minus mortgage) needs to be at or below 25%

3. Stellar credit history, including no bankruptcies in the last 7 years, no tax liens, fewer than 10 credit history inquiries in the last 6 months, and a limited number of credit accounts.

Obviously, depending on one's credit history and spending habits, P2P lending may or may not work. However, should one qualify for a loan, the percentage rates that are offered cannot be beat. For example, Lending Club currently provides personal loans for the low fixed APR of 7.88%.

The process of applying for a loan is rather simple, and involves the following steps:

1. A free online application is filled out.

2. The loan is assessed for risk (credit score, credit reports, etc.).

3. The loan is sent out to potential lenders, and each lender provides a set interest rate for the monies that are to be loaned.

4. The loan bids come back to the borrower, who selects one or more loans based on the interest rate(s) offered.

5. A processing fee of 0.75% to 3% is applied to the received monies of the loan.

If one does end up borrowing through P2P lending, it is imperative that loan payments arrive on time; otherwise, just like with a bank loan, late fees are assessed.

The flip side of P2P lending is to become a lender. The good news is that any person can become a lender, as long as the following qualifications are met:

1. A certain gross annual income (the average is $70,000, with a net worth of $70,000 (or a total net worth of $250,000)). Some state residents are required to have even higher incomes and net worth (e.g. California).

2. Usually, a credit score of at least 660 (or higher).

3. State resident (required in certain states).

Lenders can make an average of 9% interest on their loans. Of course, the rates are higher and lower for loans with higher and lower risk, respectively, and actually range from 7% to just over 20%. Also, most P2P lending companies will charge a service charge of about 1% for the amounts paid by borrowers. Luckily, the service charge reduces annual returns by less than 1% because it is not an annual charge. Keep in mind that loan default is around 3%; however, due to the fact that there are multiple lenders and borrowers involved, the risk is shared.

P2P lending can also be applied to small businesses and entrepreneurs, whether based in the United States or in other countries. The stimulus bill that President Obama signed this year will provide $6 million to help with small business lending and another $24 million for small business microlending programs. Small businesses and entrepreneurs who cannot otherwise obtain financing may look for lenders through the Association for Enterprise Opportunity directory.

Kiva and United Prosperity are two organizations that help connect lenders with borrowers from third-world countries. Lending money through Kiva or United Prosperity enables small entrepreneurs to better themselves and their local communities. Once the borrower has paid off the loan, the lender can choose to withdraw the money through Paypal or re-lend it to another borrower. Such microfinance institutions allow lenders to make a contribution towards fighting poverty and sub-standard living conditions in developing nations. Also, lenders do not need a prerequisite credit score or net worth in order to start helping people in impoverished areas of the world.

References:

"How to use peer-to-peer lending sites to borrow money", by Amy Hoak, Filife, January 28, 2008."Microfinance in the U.S.A. about to explode?" Andrea Chalups, WalletPop, February 17, 2009.