The “Peer-to-Peer” Lending Market

Peer-to-peer lending, or person to person lending, allows investors to skip the bank and borrow from other people.(1) In a time when credit is hard to come by, peer-to-peer lending has become more popular. Credit card companies have been raising rates and dropping consumer rewards.(2)

Plus, lenders can look beyond credit scores and loan money to people for a variety of reasons. “If I see a person who doesn’t have a high credit rating, and who served in the military and is just getting started and maybe made some mistakes in the past—maybe they have three credit cards maxed out and they’re trying to consolidate them—I’m more apt to invest in someone like that and give them a chance to get back on their feet,” says Hoffman, a major in the U.S. Marines. (3) Hoffman also believes that peer-to-peer lending also benefits from a general lack of trust towards banks by the public. Id.

As Hoffman demonstrates, the average person can be more forgiving of a bad credit score than a bank. The lender is taking on more risk, “but if [the lender] can tolerate the uncertainty of lending money to strangers, some with spotty credit histories, [the lender] can generate returns much better than can be gotten from most government or corporate bonds” according to Joe Light of the Wall Street Journal. (4)

Peer to peer lending can be used to pay off high-interest credit-card debt, but it can be used for any number of reasons, “such as to build a swimming pool.” Id. “The main driver, the investors say: higher returns.” Id. Safe five-year U.S. Treasurys yield just 0.9%, while higher risk U.S. high-yield, or “junk,” corporate bonds, with a duration of four years, have yields of 7.33%. Conversely, three-year loans rated B1 by a company called Lending Club, “whose borrowers typically have a FICO credit score above 720, pay a 10% average annual interest rate, according to the company.” Id.

Of course, with higher yields comes more risk. The loans are unsecured, meaning there isn’t collateral for lenders to keep if the borrowers don’t pay. Id.

Since peer-to-peer companies like Prosper and Lending Club are only a few years old, some planners say they are wary of the companies’ default projections. (5) Peer-to-peer lending is a relatively new industry; peer-to-peer lending services launched in the mid-2000s. Investors should give these loans time to mature. Whether these loans continue to be successful has yet to be seen. Id. Another downside to peer-to-peer lending is lack of liquidity. It is difficult to get money back before the loans mature, notes Trevor Welch, partner with Praesideo Management LLC.(6)

Also, unlike high-yield bonds, which sometimes recover some money in the event of a default, Prosper and Lending Club loans offer investors almost no chance of recovery. (7) Fortunately there is some Security Exchange Commission oversight (“SEC”). The SEC believes these peer-to-peer companies are selling investment vehicles and therefore subject to SEC rules. (8)

The average investor should not try and go after huge returns right away. Investors should try and mitigate risk by fully researching the credit rates assigned by the peer-to-peer companies and only get the highest-quality loans. The average investor should also diversify funds across several loans. Since investors can bid with as little as $50, it not too difficult to diversify the investor’s money.(9)

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1.    http://banking.about.com/od/peertopeerlending/a/peertopeerlend.htm
2.    http://billeater.com/tips/peer-peer-lending-too-risky
3.    http://www.businessweek.com/investor/content/apr2009/pi2009043_811816_page_3.htm
4.    http://online.wsj.com/article/SB10001424052702304587704577333801201736034.html?mod=WSJ_article_comments#articleTabs%3Darticle
5.    Id. supra note 2.
6.    Id. supra note 4.
7.    Id.
8.    Id. supra note 2.
9.    http://cashmoneylife.com/what-is-peer-to-peer-lending/