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Social Lending: How does P2P Lending Work?

written by: Sylvia Cochran•edited by: Jean Scheid•updated: 7/15/2011

Whether you call it social lending, P2P investing or peer to peer lending, the basic process is the same: money changes hands, and one party to the transaction becomes the borrower while the other party assumes the position of the lender. It sounds good on paper -- but does it deliver in reality?

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    Profitable and Cheap?

    “Dollar Symbol” by Svilen.milev/Wikimedia Commons via Creative Commons Attribution license 3.0 The Lending Club, one of the organizations that brings together borrowers and lenders, explains that investors -- in July of 2011 -- might expect returns on their investments equaling 9.64 percent. Borrowers have the opportunity to enjoy interest rates as low as 6.78 percent. Prosper, another organization in the same line of business, explains that P2P lenders may enjoy returns as high as 10.4 percent, while borrowers’ interest rates start at 7.4 percent.

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    How it Works

    The process of person to person lending is deceptively simple.

    • Potential borrowers and lenders sign up with a dedicated P2P site.
    • The borrower creates a profile, listing the amount of money needed, the purpose of the loan and also the length of the repayment period.
    • A potential lender browses the listings and decides where to make an investment.
    • When enough investors back the loan -- usually when the loan request is up to 70 percent funded -- it pays out.
    • The borrower receives the money and makes monthly payments. The client also pays between 3.25 percent and 4.50 percent -- for one company -- of the loan amount as a one-time processing fee.
    • Investors receive a portion of these monthly payments. A smaller portion, usually about one percent, goes into the coffers of the P2P site.

    Lenders hedge their bets by relying on the services’ ratings of the borrowers. Usually these ratings depend on the borrower’s creditworthiness, as defined by an official credit report.

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    It is true the borrower does not have to go through the extremely frustrating experience of applying for a bank loan and then being turned down because of creditworthiness. Considering also that plenty of banks do not write small loans, it stands to reason the P2P model is ideal for the would-be borrower with a small need or a flawed credit score.

    On the other side of the equation is the small-time investor. Potentially high returns on investment are attractive for a person with only $50 or $250 to invest. It is clear that making these investments whenever there is a little bit of extra money in the budget can, over time, add up to a generous chunk of recurring income.

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    Pitfalls and the Fine Print

    Person to person lending is not a fool-proof proposition. Quoting Prosper’s chief executive Chris Larsen, Mark Gimein repeats the former’s claim that “Every American can be their own banker. I can back other entrepreneurs, I can back people in my community, and I can make the money on this. I can do well by doing good. I think that's very empowering, and exactly what we need now to fix this crisis.” Gimein then goes a step further and likens this business model to “not a solution to the credit crisis, but a microcosm of it.”

    The reasoning is impossible to miss. The Siren song of high borrower interest rates attracts lenders who then go on to back loans that may -- or may not -- accomplish what the applicant claims. Who is to know if the ‘single mother of four’ really needs the money to ‘pay off credit cards?’ What if she is instead a young lady hoping to make it big in Vegas but needs the seed money to travel out there? On the Internet, all is not as it seems. According to 2010 figures, of the $136 million loans that Prosper investors have made possible, almost $38 million have become bad debts and were eventually charged off. Left to hold the bag were the individual investors.

    Those hoping to get a loan also face some problems. If they are deemed a high credit risk, not even a high return on investment can persuade all investors to rush to the would-be borrower’s aid. There is no guarantee that the loan will fund -- or fund at 100 percent. The cost associated with getting a loan also may be a lot higher than the big type on the website’s front page explains. For example, a low-rated loan for a Lending Club borrower may carry a 36-month APR of 27.46 percent, with an interest rate of 23.59 percent. In the same bracket, the loan origination fee is five percent. The P2P sites also make money on attempted automatic payments, late payments and check processing.

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    Done correctly, peer to peer lending can become an important aspect in America’s economic landscape. Borrowers who see it as one possibility of meeting financial obligations will not suffer if the loan they need does not fund. Investors who take an approach to P2P lending that rivals playing the slots in Las Vegas, also have the opportunity to make money -- while there is the warm fuzzy feeling of helping a fellow man in so doing. If the investments are sufficiently small -- and do not represent the lion’s share of an already cash-strapped investor’s portfolio -- it is possible to make a bit of money and chalk off the rest as ‘play money.’

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