The peer-to-peer economy has revolutionized the way people do business, and the financial sector has seen some impressive advancements leveraging P2P applications. One of the most used such applications is microlending, or microcredit. Microloans are small loans that are issued by individuals rather than banks or credit unions. These loans can be issued by a single individual or aggregated across a number of individuals who each contribute a portion of the total amount. (See also: Economic Fundamentals of the Sharing Economy.)
Often, microloans are given to people in Third World countries, where traditional financing is not available, to help them start small businesses. Lenders receive interest on their loans and repayment of principal once the loan has matured. Because the credit of these borrowers may be quite low and the risk of default high, microloans command above market interest rates making them enticing for some investors.
Microlending Risk and Reward
Microlending has been facilitated by the rise of the internet and the worldwide interconnectivity that it brings. People who wish to put their savings to use by lending and those who seek to borrow can find each other online and transact.
The credit rating of borrowers is imputed using data (including whether or not the borrower owns a home), a credit check or background check, and repayment history if the borrower has participated in microloans in the past. Even those with excellent credit scores can expect to pay slightly more than traditional credit. As a result, lenders may earn a better return than through traditional savings or CDs. (See also: Microfinance: What it is and How to Get Involved.)
Because these loans are not typically backed by any sort of collateral, if a borrower defaults, the lender may expect little or nothing to be recovered. On Prosper.com, the best rated borrower can expect to pay a minimum of 6% annually on a loan, and the riskiest borrower will pay an interest rate of up to 31.9%. If an investor thinks that 6% for a relatively safe loan is worth the risk, the loan may produce outsized returns compared to other forms of lending.
Because of the inherent risk of any one microloan, lenders often invest only a small amount per loan, but may fund a portfolio of many dozens of microloans. Therefore, any one borrower may find their loan is funded by a large number of lenders, each contributing a small percentage of the total amount. By spreading the risk across a wide array of loans with different credit qualities and other attributes, lenders can ensure than even if one or two loans default, their portfolios will not be wiped out.
Lenders of microloans are typically individuals, as professional investors and financial institutions find the risks far outweigh the reward. As a result, most microloans are peer to peer in the purest sense. (For more, see: Peer-to-Peer Lending Breaks Down Financial Borders.)
Microloans may serve one of two main purposes. The first is to help the poor in Third World countries start small businesses. The lenders are individuals who pledge a certain amount of money to loan out to a deserving entrepreneur in another country.
Companies like Kiva administer microlending for these humanitarian purposes. Borrowers will describe the type of business they wish to start, how it will operate, and present a business plan outlining day-to-day operations. Borrowers will often also feature a personal story and short biography. (For more, see: Improve Your Karma With Microlending.)
The second purpose is to lend to individuals in developed countries who may have bad credit and cannot obtain credit from banks, or who seek to borrow small amounts of money that are below the amounts required by a bank. Lending Club and Prosper are two companies that administer peer-to-peer microlending for these purposes. A borrower may seek funding for any number of reasons, which are made explicit to potential lenders. If the lender does not trust the borrower they will elect not to fund that particular loan. In some cases, loans may not be fully funded because they cannot attract enough lenders to contribute.
To date, more than $3 billion has been borrowed on microlending site Prosper and almost $8 billion through Lending Club. These companies typically earn a profit by charging fees to originate and maintain loans that are then added to the borrower's interest rate.
The Bottom Line
Microlending is a financial innovation made possible by technology and the peer-to-peer economy. People looking to lend money to earn potentially high returns may fund borrowers who either have no access to credit due to geography or cannot get credit from traditional sources, such as banks or credit unions.
Many lenders may fund a single microloan, while others may spread an investment across a portfolio of microloans to diversify their risk exposure. Microloans carry high interest rates because they are typically much more risky than other forms of borrowing and do not post collateral in case of default.