As consumers demand alternatives to traditional bank lending, more and more companies are getting into the person-to-person lending business.
The once-sunny hillside of consumer credit now looks like it's been hit by a tornado-some banks and lenders have been uprooted, while others have been completely destroyed. Amid the rubble, a lending option called peer-to-peer lending is sprouting up. Is it just a rampant weed, or is it the flowering of a whole new plant in a newly-landscaped credit garden?
P2P lending 101
As the traditional consumer credit market stumbles, peer-to-peer (P2P) lending is growing in popularity. The concept hinges on bringing consumers who have money together with consumers who need money, for the benefit of both sides. Several web-based companies, including Prosper.com, Zopa, Virgin Money, and Fynanz.com, are now offering various solutions to facilitate the practice. For example:
- Prosper.com works like a job board or auction site. Borrowers set up profiles that describe their loan needs and credit qualifications. Lenders then review those profiles and bid on the loans they like. Typically, each lender bids only a small amount so that several lenders have to share the risk of each borrower. Lenders are encouraged to diversify their P2P investment among many borrowers to reduce risk.
- Zopa has operations in the U.K., U.S., Japan, and Italy. The U.S. version allows "lenders" to participate by purchasing a federally-insured certificate of deposit (CD). The depositor/lender can then use a tiny percentage of her deposit to reduce the monthly payments on a peer's loan. As with Prosper.com, the depositor/lender reviews borrower profiles to hand-pick those who will receive the help. The loans and the CDs are underwritten by partner credit unions.
- Virgin Money offers services that formalize person-to-person loans, such as documentation, loan servicing, escrow accounts, and even mortgage closing services. This is handy for those who've already made arrangements to borrow money from Grandma or Uncle Louie, but need some help managing the transaction. The company deals in loans for mortgages, personal and business needs, and student education.
- Fynanz.com is an auction lending site that focuses on student loans. The company addresses default risk from several angles: loans are guaranteed for at least 50 percent of the principal, borrowers are prequalified and classified into risk categories, and lenders are encouraged to diversify by bidding small amounts on various loans.
Bypassing banks, but not without risk
Given the current state of the U.S. financial industry, person-to-person lending is a timely and intriguing concept. But the future of this model will depend on how well the risks are managed going forward. Peer-to-peer borrowers can default as fast, or faster, than borrowers who've been underwritten by a commercial bank. If borrower defaults run high, the pool of willing consumer lenders will undoubtedly dry up. Where there are no lenders, there will be no loans. At that point, P2P lending will be just another piece of the wreckage on the devastation that was the consumer credit landscape.