Borrowers, lenders see alternative to banks in person-to-person loans

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Borrowers, lenders see alternative to banks in person-to-person loans

By Kathy M. Kristoff
August 16, 2009

As banks continue to tighten the grip on borrowers, canceling home-equity loans and cutting limits on credit cards, Americans are increasingly turning to a timeless source of credit: one another.

Person-to-person lending, facilitated by Web-based companies, is coming of age.

"The credit crisis has put a huge crimp in the ability of the average consumer and the average small business to access credit from traditional sources," said Ed Kountz, a senior analyst at Forrester Research in Atlanta. "In a time of tightening credit, person-to-person lending has turned into an attractive alternative."

The market is dominated by three major players -- Virgin Money, Prosper and Lending Club -- though there are more than a dozen others.

These companies provide loan documents and automatic debits from the borrower's account.

The way it works varies from site to site, said Curtis Arnold, founder of CardRatings.com and co-author of "The Complete Idiot's Guide to Person-to-Person Lending."

Friends and family

Virgin Money concentrates on loans between people who know each other. If you want to hit up your parents for a mortgage loan, for example, you can get them on a conference call with a Virgin Money representative and talk through the interest rates and terms.

Virgin Money will write up the paperwork and collect the payments. The cost varies from $99 to more than $2,000, based on the complexity of the loan and how much the company does, said Tim Burke, social-lending sales manager at Virgin. If you have it process payments, Virgin Money also collects a fee each time a payment is made.

Virgin Money doesn't dictate the terms, though it will provide warnings if the loan's interest rate is so low that it's likely to trigger tax problems or so high that you're likely to run afoul of state usury laws. The rate and repayment schedule are set by agreement between the borrower and lender. No credit reports are necessary.

Total strangers

Lending Club or Prosper aim to bring strangers together to finance small businesses, refinance credit card loans and provide student loans, Arnold said.

To protect borrowers, lenders are not given access to the their personally identifiable information. That reduces the chance an anxious lender will directly contact a delinquent borrower for payment. Once lenders agree to fund a loan, they're cannot back out.

To protect lenders, the sites pull credit reports on each potential borrower. Lending Club and Prosper have grading systems to handicap the likelihood of default. Lenders use these risk profiles to determine whether to fund a loan and how much interest to charge.

Prosper demands that lenders get returns commensurate with the risks they're taking, a company spokeswoman said. To determine interest rates, the company uses the going rate for a low-risk investment such as a certificate of deposit and adds points based on the likelihood of default.

"We have a system that we think ensures that both sides get a fair deal," said Chris Larsen, Prosper's chief executive and co-founder.

Risk and reward

Peer-to-peer borrowing represents an investment.

"I could invest my money and get 2 percent in a money market account or I can get 7 percent to 9 percent lending it out," said Arnold, who has made person-to-person loans. "And if you're able to lower somebody's credit card rate to 9 percent, that's great for them too."

But it's risky business, said Bobbie Britting, research director of consumer lending at TowerGroup.

Since its inception in 2006, Prosper has a 19 percent default rate, Larsen acknowledged, but it has tightened its criteria. Virgin Money reports that about 5 percent of its borrowers don't pay.

"You should ask yourself if you can afford to lose 20 percent of your investment," Britting said. "Lending is inherently risky. You have to be prepared for that."

"Lending is inherently risky. You have to be prepared for that."

--Bobbie Britting, TowerGroup
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