When bank lending slows down, as it did during the 2007-08 financial crisis, people start to have more trouble accessing the credit markets. But that doesn't mean they stop looking for ways to borrow. They just need to look a little harder to find available loans at lower rates. Similarly, in a credit crunch environment, individual investors are desperate to find higher returns than those offered by stingy bank certificates of deposit (CD).
For borrowers and investors alike, the solution a growing number of them are turning to is ... each other. In fact, a time-tested method is gaining ground with the growing popularity of websites that make it possible to bypass the banks altogether. They're called peer-to-peer lenders, and according to TechCrunch, peer-to-peer loans have recently passed the $1 billion per month mark, and that number is expected to keep growing too.
Who Are These "Peers"?
If you're looking for a cheaper way to pay off credit cards or consolidate debt, this might be an option for you. First, perform a quick Internet search for a website that compares the different peer-to-peer sites available; a key-word search of "peer-to-peer lending" (P2P) should provide plenty of results. Most companies work in a similar fashion, so it's important to choose a peer-to-peer lending service that is well established and has a large active membership of borrowers and lenders. The basic process, according to Peer Lending Network, an affiliate of peer lender Prosper.com, goes like this:
1. A person seeking a loan posts a listing with the amount of money they hope to borrow and the rate they can afford to pay for the loan.
2. Lenders bid on the listings, submitting the amount and rate they are willing to offer. The more competing bids there are, the lower the borrower's interest rate will be.
3. When the listing is complete, the qualified bids are combined into a single loan for the borrower.
4. After the loan is fully funded, the loan amount is deposited directly into the borrower's bank account.
5. Fixed monthly amounts are then automatically withdrawn from the borrower's bank account each month and sent to the lenders until the loan is repaid.
For at least one P2P website we examined, lenders purchase notes from the company. With these payments, the company funds the loans to the borrowers. The borrowers then pay their monthly fee to the company, which in turn makes the payments to the lender. As such, the P2P company is not responsible for making the payments to the lender if the borrower does not pay, so the lender's risk is still tied to the borrower. It does, however, allow the P2P company to deduct a 1% service charge on the loan. Lenders should keep this in mind while calculating their expected rate of return.
Examine the Details
P2P websites tout their great interest rates and easy loan process for both borrowers and lenders. In theory, risk is reduced because lenders can spread their investments over thousands of borrowers to reduce risk.
Nothing, however, is ever as good as it seems. We already mentioned the service charge for the lender. One thing borrowers need to look out for is the fees associated with closing the loans on these P2P websites. The initial interest rates look attractive, but you have to account for everything. We found that on average, a one-time 3% transaction fee is charged any time a loan is closed. That's how these P2P companies make their money. If you lend money at an 8% rate, then your real rate will be 11%. In addition, fees are assessed to the borrower when he or she misses payments.
You should be very careful if you're looking to consolidate loans and lower your interest rate because you could wind up paying a higher aggregate rate. That's not to say that these loans aren't a great way to access credit and find lower rates. They can be - especially considering credit card rates - but only if you approach them responsibly.
A quick note to remember as a borrower is that these loans are usually based on a three-year repayment plan. You do have the option to prepay the loan, but you won't be able to reduce your overall interest payment because you paid the loan early.
Who's Doing the Due Diligence?
If you're a lender, you're going to be worried about credit worthiness. How are you supposed to know whether the borrowers on P2P networks are reliable? Well, the P2P websites work with the credit agencies to determine borrowers' credit quality. Each of the top lending P2P websites requires a credit score of at least 660 or more just to participate. As a lender, you'll be able to see the quality of each loan being requested, so you can further tweak the riskiness of your portfolio based on your tolerance.
Below are a few more examples of borrower criteria, although these can vary between networks:
- A debt-to-income ratio (excluding mortgage) below 25%
- A credit report with no current delinquencies, recent bankruptcies, tax liens or non-medical related collections opened within the last 12 months and reflecting:
- At least four accounts ever opened
- At least three accounts currently open
- No more than 10 credit inquiries in the past six months
- Use of available credit not exceeding 100%
- A minimum credit history of 36 months
- U.S. citizen with a valid Social Security number
- An account at a financial institution with a routing number
When the Standard Route Fails
A P2P lending service can be a great way for people to cheaply access the credit markets during times when banks are restricting lending. Even people with excellent credit quality have been turned down by banks for personal loans based on other metrics, or just a sheer unwillingness to part with their taxpayer-supplied cash cushion. However, if you aren't quite comfortable with this process yet, try another comparable service, such as that offered by Lending Tree, which allows banks to compete with each other for the right to service your loan.