July 14, 2009

The current economy has created challenges for both the cash rich and cash poor.  With interest rates at historic lows, the former have few places to safely put their money while still earning a significant return.  Meanwhile, the latter faces difficulty in finding the capital they need to effectively run and grow their business because of tightening credit.

Enter the concept of peer-to-peer (p2p) lending, which has been growing in popularity significantly over the past few years, from an estimated $118 million in 2005 to $647 million in 2007 to a projected $5.8 billion in 2010, according to research firm Celnet. 

What Is It?

The idea is pretty much what the name implies: instead of going to a bank for a loan, you go directly to other people willing to lend money.  Borrowers are evaluated similarly to the way a bank would evaluate you – your credit score and history, line of business, and assets. 

However, because it’s p2p, there are potentially thousands of individuals looking to loan out money and earn a return at any given time, considering both quantitative and qualitative aspects of the loan applicants. 

Those lenders are willing to lend via p2p sites because they typically offer a far better return on average than putting the money into a savings account, CD, or savings bond, especially at this point in time.  And the risk isn’t necessarily that much higher (more on that later). 

How Do You Get Involved?

Until recently, the most widely used p2p lending site was Proper, a competitive p2p marketplace where lenders bid on loans – essentially, competing with each other until no one would go any lower on the interest rate.  However, as of May, 2009 the site is currently down as the company awaits SEC approval for its service (initially, p2p lending sites operated outside the regulation of the SEC, but that has since changed).

LendingClub, which has been approved by the SEC, is quickly filling Prosper’s shoes.  According to company executives interviewed for a recent article in BusinessWeek, “loan volume has doubled since the fourth quarter of 2008” and the service will “process $150 million worth of loans this year and $350 million in 2010.”

When you apply for a loan with LendingClub, the service will issue you a grade, A-G, with “A” grade offering the lowest interest rate (as low as 7.37 as of 7/2/09) and “G” running as high as 20.11%.  Investors can then browse these applications, and make broad investments based on their desired return and level of risk tolerance, or use search options to filter for specific types of loans and evaluate them based on other characteristics, like the purpose of the loan.
 
Throughout the process, LendingClub doesn’t show lenders any personally identifiable information.  All loans are for three years, with your payments being drafted monthly from your bank account. 

What’s the Risk?

As a borrower – there’s not much risk in using a service like LendingClub or Prosper.  If the bank has turned you down or offered unfavorable terms on a loan, it’s certainly worth filling out an application and seeing if you can get a loan via a p2p site.

As a lender, the risks aren’t as high as you might think.  LendingClub rejects the vast majority of applicants, and BusinessWeek notes that only “4.2% have defaulted and another 3% are between 30 and 120 days late.”  In exchange for that level of risk, lenders are seeing an average return of 9.75% annualized as of 7/2/09.  Prosper, however, has had a much higher default rate – 20% according to the same BusinessWeek article.

Ultimately, p2p lending is an interesting concept that should see more activity from small business, especially as banks remain reluctant to issue loans.  Meanwhile, if you’re in the fortunate position of having excess cash to potentially invest in p2p lending, don’t let the attractive interest rates lure you in too deep.  At this point, it’s best to treat the space like any investment and make it only a small piece of your overall portfolio.     

Image courtesy of iStockphoto, AlexKalina