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Maybe you’ve heard of peer to peer (p2p) lending. It’s also known as social lending or person to person lending. What is it and how does it work? I have some experience in this area so read on to find out what p2p lending is all about.

Borrowers

Consumer loans are big business. According to Wikipedia there is a $2.5 trillion (that’s 25 followed by 11 zeroes) consumer lending market in the United States. That’s not including mortgage lending.

Consumer lending can be incredibly profitable. Consider that a payday loan can carry interest as high as 780% for a loan as small as $100 and you’ll understand why so many pay day loan stores have opened in recent years.

There’s a huge consumer lending market with large profit potential. Now mix in the incredible power of the internet and you have a recipe for innovation. If you could match borrowers with lenders while cutting out the middle man, you’d have the potential for a profitable business. Online lending sites like Prosper are hoping that's the case.

Savers

While the US savings rate may be negative, there are still many people who have money in a savings account. Considering that traditional savings accounts at banks like Wells Fargo pay a very low APR (interest rate), it should be easy to convince many savers to do something else with their money.

Banks, like ING and HSBC, have begun to offer online only savings accounts. These accounts may pay many times the average of traditional savings accounts. HSBC claims they pay “7x the national savings average.” However that rate is now only 3.05% which is barely keeping pace with inflation.

Connecting Borrowers and Savers

Borrowers are looking to borrow at lower rates and savers are looking for a higher rate of return. Sites like Prosper connect the two groups. These sites attempt to eliminate the traditional middle men, banks and others, and replace them with a much more efficient middle man, the web site itself.

Banks grew out of a need to connect savers and borrowers. Up until very recently the only way to cut down risk and ensure profits was by pooling a lot of savers money together to create loans. Borrowers would charge a higher rate than what was paid to savers. The difference between these rates (and any other fees) would be the bank's profit. The bank could then pay its employees and cover it lending risks.

Social Aspects

Some people feel that banks take away the social aspect from lending. These people think you should lend to those you know, a sort of “neighbor helping neighbor” philosophy. This has also been called the “virtuous circle.” Those with money lend to those in need. When the first group of borrowers is financially stable, they can in turn lend to a new group of needy individuals.

Peer groups present another social opportunity. Members of a group might recommend other members to lenders. A member could vouch for another member. The group may be directly or indirectly responsible for a member repaying a loan. This may make lenders more willing to lend money to those with otherwise poor risk indicators like a low FICO score.

Whether social pressure or the "virtuous circle" actually work in practice remains to be seen. The virtuous circle model sounds a little too Utopian. Group peer pressure may work but it depends on how its implemented. As I examine the various p2p lenders, I’ll talk about how they use groups and social strategies in general.

The Sites

There are currently several major peer to peer lending sites. These include Prosper, Kiva, Lending Club and Zopa. Each one of these sites deserves its own article and they will get one in the very near future. For now I’ll just outline the basics.

• Prosper

  Prosper uses on online auction site to match lenders to borrowers. Borrowers set a maximum interest rate they will pay. Lenders bid on loans by setting the amount of the loan they want to contribute ($50 minimum) and the lowest interest rate they are willing to receive. The lowest bids at the end of the auction are grouped together into a loan. The interest rate on the loan is the average or aggregate of each individual loan. I have some experience with Prosper which I’ll outline in future articles.

• Kiva

  Kiva means “unity” in Swahili. It’s a non profit organized specifically for lending money to people in developing countries. Lenders make no money with Kiva. This is a pure charity organization. Kiva does have repayment rate of 99.7% which is pretty good considering what they’re doing.

• Zopa

  Zopa stands for Zone of Possible Agreement. Zopa was started in the UK and has just recently expanded to the US. They operate much like Prosper, but their system is a little different. Lenders money is distributed among many borrowers. In this way no one lender is exposed to losses from any one borrower. This would seem to be much less risky than the Prosper system, but more research is required. Zopa also considers nontraditional aspects like attitudes about money when determining a borrower’s credit worthiness.

• Lending Club

  Lending Club utilizes a matching algorithm instead of an auction system like Prosper. The algorithm tries to match you based not only on risk level and risk tolerance but also on location, educational background and existing social network relationships. The theory is that you are more likely to repay a loan to someone you have a connection with already. If you know you might run into the person at the grocery store or you have a common friend on Facebook, you might be more motivated to pay back the money. Whether this theory holds true or not remains to be tested.

Conclusion

Peer to peer lending is all about one person loaning another person money in a semi-direct manner while trying to cut down on costs. It seems like a good idea in theory. I have some opinions on the matter that I’ll share in future posts. I have the most experience with Prosper but I will be creating accounts with a few others to see how they work (or don’t work).

Article Links

Pay Day Loans en.wikipedia.org

Peer to Peer Lending en.wikipedia.org

Social Lending en.wikipedia.org

Tags    Lending Club    p2p    Peer to Peer Lending    Prosper    Social Lending    Zopa

Related Posts

• Moving My Money Away From Prosper
• What is Prosper and How Does it Work?
• Lending Money on Prosper: What Are the Risks?
• Lending Money on Prosper: My Results
• Prosper Increases Maximum Interest Rates

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