Peer-to-peer lending has existed for thousands of years. If you have ever loaned money to a friend, then you have participated in it. But it is only in the last few years that it has moved beyond just the exchange of money between friends and family. Today, peer-to-peer lending is becoming a big new industry that is independent of the traditional financial system. But before we delve into this topic let's get some clarity. What exactly do we mean today by peer-to-peer lending?
What Is Peer-to-Peer Lending?
Peer-to-peer lending has always been about a financial exchange between individuals. People who want to borrow money (borrowers) connect with people who have money to lend (lenders). The main difference with peer-to-peer lending today is that both parties can have no relationship whatsoever and still have a safe and successful transaction.
Today, online platforms such as Lending Club and Prosper are making it easy for individuals to both borrow and invest money. These companies use sophisticated screening and credit checking to ensure that borrowers are credit-worthy and can afford the loan. This gives investors confidence that their money is safe when they invest in a borrower whom they have never met and know very little about.
Peer-to-peer lending just makes good cents. Photo credit: epSos .de. Used under Creative Commons license.
How I Got Started with Peer-to-Peer Lending
I first became interested in peer-to-peer lending back in 2008 after I had sold my second business. Interest rates had gone down to almost zero and the stock market was tanking so I was looking for an alternative investment. I read an article online about Prosper and I was hooked. I loved the concept of investing in my fellow citizens, cutting the banks out of the equation, and pocketing the returns for myself. From the beginning, I felt that the idea had potential.
So, I invested a small amount of money to give it a try. After a few months, even though I had had a couple of defaults, I could see that the returns were better than most of my other investments. So I moved more money, including some retirement accounts, into Lending Club and opened up an investment account at Prosper, as well. Since then, I have become so bullish on this idea that I author a blog called the Social Lending Network that helps investors and borrowers learn about this great new investment.
Two Sides of the Equation
Most people think that peer-to-peer lending matches borrowers with lenders; but that is not entirely accurate. In order to explain the process, it is easiest to run through an example.
A borrower applies for a loan by filling out some online forms at Lending Club or Prosper. Depending on their credit score, they can apply for up to $35,000 at Lending Club and $25,000 at Prosper. In our example, let's say the borrower applies for a loan of $10,000. After providing appropriate personal information, the borrower will be notified if they qualify for a loan and what their interest rate will be.
Now, an investor might have $5,000 to invest, but it is very rare for an investor to come along and invest all of that money in one loan. In fact, that is considered a very bad idea. What an investor should do is look at the hundreds of loans available on Lending Club or Prosper at any one time and invest small amounts of money in many loans; the minimum is just $25 per loan. So, our investor in this example might have a portfolio of loans (They are called notes.) with up to 200 different borrowers, one of which might be for the borrower in our example.
Typically dozens–or even hundreds–of investors will combine to fund any one particular loan. It is better for investors to diversify among many different borrowers to minimize the impact of any one default. These loans are unsecured, which means that if the borrower defaults, there is no recourse for the investor–they will typically lose their remaining principal on that loan.
Social lending is a great way to put your money to a shareable use. Photo credit: Philip Taylor. Used under Creative Commons license.
How Peer-to-peer Lending Is Evolving
Many investors are enjoying excellent returns. As this recent article in Forbes pointed out, 10 percent returns are not uncommon. What this has meant is that larger investors are becoming attracted to peer-to-peer lending and it is becoming a real asset class in its own right. Some financial advisors are recommending peer-to-peer lending to their clients, and institutional investors such as hedge funds and pension funds are now getting involved. New individual investors continue to flock to the platforms, as well, lured by the returns on offer.
Peer-to-peer lending is really just beginning. Even with the large volume of loans being issued today, it is still a miniscule percentage of the total consumer lending market. But it will continue to grow. And, one day in the not too distant future, it will be considered an essential part of the financial system.
In my next post, I'll share a step-by-step how to on getting started in social lending.
UPDATE: go here for part two of this post, Peter's guide to getting started in social lending in seven steps.
Peter Renton is the editor and publisher of the Social Lending Network, a blog dedicated to teaching people about peer-to-peer lending.