Never a borrower nor lender be. This maxim from Shakespeare’s Hamlet might have been good advice in the past, but following it today could leave you unable to climb the economic ladder to financial security and/or watching your hard-earned assets eroded by inflation. The key is to borrow and lend intelligently. Lending as an Investment Multi-million dollar businesses have been built upon lending – banks and credit card companies are examples that come to mind. But how can an individual participate in this lucrative sector? A new group of companies have sprung up in the past 5 to 10 years to make this investment class more accessible to the individual. These companies are known as peer-to-peer lending intermediaries. Peer-to-peer lending refers to the practice of lending and borrowing money without going through a traditional intermediary such as a bank or credit union. Therefore peer-to-peer (“P2P”) companies are not banks; they themselves do not collect funds from savers or make loans. Instead, P2P companies provide online platforms which connect individuals who wish to lend money to other individuals who wish to borrow money. The company then takes a fee for facilitating the transaction.
Peer to peer lending originated in the non-profit sector, an evolution of the microfinance industry. Kiva is the best known organization providing this service. Kiva enables people to lend sums as small as $25 to individuals in developing countries. Kiva and its local partners screen borrowers and track loan repayments.
The rapid growth of organizations like Kiva and the explosive popularity of crowdfunding [http://whatis.techtarget.com/definition/crowdfunding] sites like Kickstarter, attracted for-profit companies to the sector. The United States and United Kingdom led the way with companies such as Prosper and Lending Club (US based) and Zopa, Funding Circle and Ratesetter (UK based). The P2P markets in the U.S. have issued over $1 billion of funded loans.
Big P2P companies can also be found in other European countries as well as Asia. Examples include Auxmoney in Germany and MoneyAuction which covers much of the Asian market of which China and South Korea account for 95% of loan volume. Large private investors are betting on a massive consumer shift from bank and credit card loans to peer-to-peer lending and are backing their beliefs with millions in investment.
How Does it Work?
Investors sign up and receive a member account that they fund from their bank accounts, much the way that you might fund your Paypal account. Initially you will determine the type of loans you wish to provide. While the exact format will differ based on the site, P2P companies all need to address the following questions:
- How much interest do you want to earn on your money? This is your return target.
- How much risk are you willing to take? Generally, the higher the risk, the higher the possible return.
- For how long are you willing to lock your money into a loan? This is really a subset of your risk appetite; all else being equal, longer term loans are riskier due to their lack of liquidity.
Between 50 and 90 percent of borrower applicants are rejected outright. For those that are accepted, both Lending Club and Prosper grade them on a scale of credit-worthiness and assign them interest rates. You, the investor, then review the loan listings and invest in those that fit your criteria. In the case of U.S. P2Ps, when you bid on a loan you are actually making a commitment to purchase Notes linked to the borrower or borrowers to whom you’ve chosen to lend money. Notes are products issued by the P2P company that disburse payments corresponding to the repayments the borrower(s) are making. The repayments are deposited directly into your member account.
Investors can select individual borrowers or use an investment tool on the site that will automatically select borrowers that meet a set criteria. The latter is recommended as it allows investors to diversify across hundreds or thousands of borrowers. For example, instead of lending $500 to an individual, you can lend $25 to 20 people with the same (or for more diversity, different) risk/return profiles. It’s much less likely that all twenty people will default.
Borrowers register on the P2P site and verify identity, submit credit information and complete bank account authentication. If approved, you receive a grade that indicates your risk of default. Then you input your loan request and are subsequently shown several loans for which you qualify. You then select this loan for your loan listing. The listing is still a request for funds. At this stage, Prosper encourages you to advertise your loan through social media and possibly receive some of the funds from friends and family. When the loan is funded, the capital is deposited directly into your member account and can then be transferred to your bank account. Repayments are automatically deducted from your member account. Your grade on the site is based on your credit score, your debt to income ratio (which indicates if you will have sufficient cash flow to pay off the debt), credit history, personal income, loan term and the overall economic environment.
If the loan is funded, borrowers pay an origination fee. Borrowers may be subject to other fees for late payments or non-electronic payments such as checks.
Because P2P intermediaries do not have the high overhead costs of banks – physical branches, deposit insurance, marketing expenses- their operational costs are far lower. This cost savings results in lower financing costs for borrowers and higher returns for lenders. Lending Club investors will pay a 1% service fee on the repayments received by investors, effectively less that 1% since it is not annualized. Prosper investors will pay 1% annually on the outstanding principal balance of the loan due to the investor.
Prosper’s safest borrower rating, AA for a 3 year loan, is charged an interest rate of 5.5% minimum. Lenders can expect a minimum return on such a loan of 4.25% (includes impact of possible loss). In comparison, the average annual yield of US savings accounts is less than 0.1%. While borrowers must leap a high bar of credit quality, they benefit from a faster approval process and cheaper interest rates. Lending Club remarks that “As of April 8, 2013 every investor with 800 Notes or more purchased directly from Lending Club has experienced a positive return regardless of the timing of investment or the allocation across Note grades.” Similarly, Prosper states, “For Notes purchased since July 2009, every Prosper investor with 100 or more Notes has experienced positive returns.”
In addition, borrowers have significant flexibility in how they may use their loan proceeds. Borrowers spend their loans to pay off higher interest debts, for house renovations, to start small businesses and to finance cars, among other purposes.
The biggest risk to investors as the risk of default. While P2P intermediary companies tout their positive return track record, the fact remains that investor funds are not FDIC insured as amounts under $250,000 are in traditional financial institutions. Secondly, the loans are unsecured, meaning they are not backed by collateral the way a home mortgage or car lease is backed by the underlying asset. Prosper Marketplace and Lending Club are the two largest P2P companies in the United States. To be an investor (i.e. lend out money) one must reside in one of 30 states listed on their websites and have either adjusted net income or net worth of $70,000. These restrictions are required by the Securities & Exchange Commission, which regulates the industry, because the loans are unsecured and uninsured. Worldwide, most P2Ps are jurisdiction specific to comply with international anti-money laundering laws. Both sites also limit investors to lending no more than 75% of a requested loan and recommend that investors diversify across multiple loans. If a borrower falls delinquent, Lending Club and Prosper employ a collections agency. Successful collections are subject to a collections fee.
For qualified borrowers, risks are minimal. Like other types of debt, if you become delinquent it will negatively impact your credit score and a collections agency will attempt to collect the debt. Secondly, there is a chance your loan will not be funded if no investors are interested in the particular risk/return profile of your requested loan.
The Final Say
Peer-to-peer lending can be a great method for investors to diversify their portfolios and access high returns in the current market. However it is critical that investors understand the nature of the risk they are undertaking.
Qualified borrowers have little downside. Peer-to-peer lending can provide another credit option. Borrowers should compare annualized rates and other fees to ensure they are getting a good deal. As a borrower, if you qualify, you can likely access cheaper rates through peer-to-peer lending versus a credit card or bank.