Peer-to-peer lending: a good alternative to banks and credit unions?

Are you searching for a loan to get college education, replace credit card debt, start a new business or make home improvements? Slowing economic activity and slumping home values have made borrowing increasingly difficult. Is there any way out? Consider peer-to-peer lending. It is a reliable way to take fixed-rate loans online directly from individuals. 

Many deserving customers, who once get approved for beneficial home equity or personal loans, now can’t qualify for any unsecured loans. Even people with good credit are finding it harder and more expensive to borrow from traditional sources.

As banks are tightening their lending, a new industry is emerging to help customers navigate economic uncertainties: peer-to-peer lending. Many borrowers consider it as an easier way to get money at favorable terms than through traditional sources. 

P2P basics

Peer-to-peer lending, also called person-to-person, social or P2P lending, has been around since 2005. It means a certain type of financial transactions (primarily lending and borrowing) between individuals ("peers") without the intermediation of a bank, credit union or other financial institution.

With peer-to-peer lending, individuals can borrow money from ordinary people. Lenders compete with each other to make loans in an eBay manner. It often results in lower interest rates for borrowers – on average, from 8% to 16% - than are available on unsecured loans from financial institutions. 

On the return side, lenders get returns that might range from 5% to 11%. It is certainly more beneficial than to invest money in CDs with 2%-3% APY. Many lenders consider P2P loans as a part of a diversified portfolio strategy: stocks, bonds, bank accounts and P2P loans.

Lenders have the opportunity to choose who they want to lend money to and at what rate they can make a loan. This decision is based on the borrower's credit history and current debt. Generally, the basic principle of lending is traditional: the lower your credit score, the lower your chance of getting financed. 

Sometimes lenders also take into consideration social factors: what the reason is for a loan or whether the applicant has the same occupation as the lender. For example, some lenders can make loans to military personnel even if they have average credit score. On the contrary, when you are dealing with a bank, they are not interested in your life stories.

Another advantage of P2P borrowing is the opportunity to improve your credit score. If you have a bad rating, no bank would let you qualify for a beneficial unsecured credit card or personal loan. In this case you can take a small P2P loan and make regular payments on time. The site will report your payment history to credit bureaus. It will help you prove your financial responsibility and creditworthiness. 

There are three main types of P2P loans:
•    Personal loans
•    Business loans
•    Student loans
Typically, loan amounts range from $1,000 to $25,000. Of course, lending money is always associated with risk. Instead of earning a +12% return, you can get somewhere between -2% and +6%. However, default rates for peer-to-peer loans are lower than for other types of loans. 
Most lenders prefer to spread their investment risk by lending small sums to different borrowers – from $50 to $200. Thus a loan to a borrower is funded by multiple lenders. For example, you can make 20 loans, for $50 apiece. If one of your borrowers defaults, you will not lose all your money.

How P2P websites work

Peer-to-peer websites profit from fees they charge lenders and borrowers for their service. They also perform credit checks, and contract with third parties to collect on bad loans.
P2P websites work similar to eBay:
1.    People looking for a P2P loan post a listing with the amount of money they need at a rate they can afford. They also publicly disclose their credit history and some personal information (stories of hardship and family photos sometimes help).
2.    Lenders compete with each other by posting the amount and rate they are willing to lend the borrower. 
3.    When the listing is complete, the bids with the lowest rates are combined into a single loan for the borrower. 
4.    The borrower makes regular monthly payments to the website, and it divides the payments among lenders and deposits them in the lenders' bank accounts. 

There are many resources that bring individual borrowers and lenders together. The most popular are:

Prosper.com
Prosper is an online community for lending and borrowing money. It was created to make consumer lending financially and socially rewarding for everyone. Nowadays there are over 830,000 members and $178,000,000 in loans funded on Prosper.

Prosper works similar to an online auction. Instead of listing and bidding on items, people list and bid on loans using Prosper’s online auction platform.

LendingClub.com 
Lending Club is the leading P2P lending network that brings together borrowers and individual investors. Each loan request made by a borrower is qualified according to the grade ranging from A1 to G5. 

Borrowers with good credit can get personal loans from $1,000 to $25,000 at interest rates that are often lower than rates from financial institutions. Lending Club has already funded over $18,458,000 in loans. 

Credit crisis and P2P websites

The economical uncertainty has also affected P2P industry. Since investable assets of most people have declined, people started to offer fewer funds for lending. Right now, there are more borrowers than lenders. 

The number of potentially qualified borrowers has become lower due to the increase in unemployment and numerous personal defaults. However, tightening lending market is pulling people to P2P websites. So even if the approval rate is going down, the number of applications is raising. 

In addition, due to stock market decline and numerous investment scams, many people consider P2P lending as an alternative investment solution and excellent diversification strategy.

That’s why credit crunch won’t write off P2P lending model. The market for the loans is growing fast, according to Celent, a research firm. It projects that $5.8 billion in peer-to-peer loans will be made in the USA by 2010.