Peer to Peer (P2P) Lending
Peer to Peer (P2P) Lending
A possible alternative to Banks
Lara Miller began showcasing her original fashion designs as a student of the Art Institute of Chicago. Six short years, a landslide of favorable press and 17 retail outlets later, the Lara Miller brand needed an influx of cash to keep up with demand and fuel the growth.
After borrowing from family, friends, and credit cards, Lara ran into a cash squeeze. Like many small businesses, she didn’t have the credit history or the collateral to get bank financing. For all her success, without a small business loan or line of credit, Lara was faced with going out of business.
“Fortunately, a friend told me about Prosper,” Lara says. Within minutes of visiting Prosper’s peer-to-peer lending site, Lara posted her listing and, “It was amazing. I posted the loan, and almost immediately, I had 8 bids.”
Lara’s first loan for $3,000 was funded at 10% APR –dropping from a listing of 14% in the first day. Since then, Lara has taken out two more loans with Prosper to fund a new website and help launch a new line of fashions.
From the Prosper.com website
An interesting trend has occurred over the last few years which functions like a cross between a traditional bank and EBay. It is known as Peer to Peer Lending or P2P. It has helped thousands of people who might not otherwise get loans or a reasonable rate of interest. Some investors, looking for another option to generate higher yields on their investments, have put money here.
P2P Lending is distinguished from Microfinance, which usually deals with very small loans ($1,000 and less) and usually managed by non-profit groups. P2P lending generally involves loans ranging from as small as $1,000 up to $35,000.
The two largest players in the U.S. market are Lending Club which has made over $2 billion in loans since it started in 2007, and Prosper, which began in 2006 and has arranged about $550 million in loans since its inception. The growth in these two companies has been extremely impressive with a rate of over 195% over the last year. This growth has not gone unnoticed as Google recently purchased 7% of Lending Club, and Lending Club is expected to issue an initial public stock offering in 2014.
HOW DO THEY WORK?
These sites essentially act as middlemen, matching up borrowers with lenders (investors). Investors bid online for the right to participate in the investment group providing financing to a specific borrower. No banks or credit lenders are involved in the process which generally results in a much lower interest rate than offered by banks. Investors may get a higher interest rate than with publicly traded bonds. However there is always the risk of loss if borrowers default. If you understand and spread the risks among several borrowers, it has potential for aggressive investors.
Borrowers need a minimum credit score ranging from 640 to 660, and have to pass a credit screening process demonstrating a good credit history. Income and employment are also verified if included in the listing. Only about 10% of applicants to Lending Club qualify for a loan. If a borrower is delinquent or defaults it is reported to the credit reporting agencies and collection agencies are involved. All borrowers are anonymous to their investors, so you cannot find a deadbeat who defaults and crack their kneecaps. Borrowers also pay a loan origination fee ranging from 1% to 5% depending on the grade of the loan. The loan terms are 3 or 5 years and interest rates can range from about 6% for the highest quality loans up to almost 30% for the lowest rated borrowers. There are no prepayment penalties which can reduce the overall return to an investor.
Lenders (investors) have to live in one of the 28 states that support Lending Club or one of the 31 states that support Prosper. They must also have at least $70,000 of annual income or have a net worth greater than $250,000. Investors don’t pay to sign up but pay over 1% of their earnings per year as a fee to the P2P service. Remember, these are for profit entities.
Investors can pick and choose from thousands of loans. Each loan has some background information about the borrower, the amount and term of the loan, the grade (quality) of the loan and the interest rate assigned to the loan. Lenders can ask questions of the prospective borrower as well. You can invest as little as $25 per loan and it is recommended that you spread out your investments to get good diversification of your loan portfolio. Corporate bonds that default may still allow you to recover a good portion of your investment. You will probably get nothing back from loans that do default in the P2P lending arena. Obviously, none of the loans you make are FDIC insured but amounts that are currently not invested are held in FDIC insured accounts. You can also sell your notes to other investors if you wish.
For investors that wish to invest $10,000 or more and do not want to spend the time researching, both Lending Club and Prosper have a Prime account and they will automatically fill the account with an appropriate selection of $25 notes.
Since its inception, loan default rates for Lending Club have ranged from 1.4% for top rated three year-loans to 9.9% for the riskiest loans. (per Forbes article in 2012). Overall returns for investors have been returning 5% to 6% to investors while lower quality loans have been returning well over 10% (after charge-offs for bad loans) to more venturesome investors. The Great Recession was starting when these firms commenced operations, so their experience has generally been during improving economic times.
There are also websites that help you design filters for loans to look for and strategies to improve your returns. It is highly recommended that you spread out among a large amount of loans. Using filters in your search process can save you a lot of time in choosing which loans to look at and decide to invest in.
Some aggressive investment advisors are even taking things one step further and utilizing P2P lending as an addition to their high yield asset class. Hedge Funds are starting to take note as well. The loans have had steady returns since these companies inception.
It may not be all that long before P2P lending becomes more commonly accepted. It has already done well in consumer lending, and small business lending is likely the next frontier for P2P lending. We would recommend waiting for a full economic cycle to check performance in more difficult times.
The preceding article should not be considered investing advice or as a recommendation to purchase securities. It was written for informational purposes only.