What Is Peer-to-Peer Lending?

TheStreet

You need some money but don't have it. There are a few traditional ways to fix that. Credit cards are the most common form of short-term lending for Americans, but are often quite expensive.

Banks may also offer unsecured personal loans, but these are more complicated to get. They can require better credit, lots of paperwork often require a relationship with the institution, and are generally geared towards high-value lending.

In this environment there's a need for what economists call "microlending;" small, often short-term loans that people can access easily and pay off inexpensively. This has long been a prominent feature of global aid spearheaded by institutions such as the NGO Kiva. In the U.S. we call it peer-to-peer lending, and it's catching on.

What Is Peer-to-Peer Lending?

Some readers might know peer-to-peer, or P2P, best from their file sharing days. In network architecture peer-to-peer means any system that connects users directly. The role of a central system in peer-to-peer networking is to route and organize traffic. It doesn't actually conduct any transactions.

(When faced with copyright infringement claims in the early 2000's, companies like Limewire relied on this as a defense. The companies argued that they were simply a routing station for transactions conducted by users. It is substantively the argument made by social media networks to defer liability for user-generated content.)

This is as opposed to a centralized network, in which the central system or company conducts every transaction with the user directly. In the financial space, a bank would be the archetypal centralized network. Customers borrow, deposit and invest directly with the bank.

Peer-to-peer lending is a decentralized financial network. On a P2P website users lend and borrow directly among themselves; think crowdfunding, but with loans instead of investments. The loans are generally, although not always, fairly small and are funded by individual users rather than the central company. The role of the company is to connect users and to ensure fidelity of the transactions.

It has become incredibly popular in recent years. According to a study by PWC, P2P platforms lent more than $5.5 billion in 2014 and the industry as a whole is currently valued at $3.3 billion.

That said, readers should be careful of careless metrics within this market. Decentralized networks have entered an era of high enthusiasm, which can distort analysis, reporting and market value. Suggestions that P2P lending will reach nearly $1 trillion within the next few years, like suggestions that blockchain will end capitalism, should be approached with healthy skepticism.

How Does Peer-to-Peer Lending Work?

As discussed above, P2P lending works much like crowdfunding. Individual lenders, typically called "Investors" by the industry, put money into an account from which they'll give out loans. Borrowers apply for loans either entirely through one investor or across multiple different individuals. This activity is coordinated by a central website, which hosts the lender's account, sets interest rates and handles all of the money transfers.

For example, someone seeking a $5,000 loan might apply through the popular website Prosper Marketplace. Their loan, if approved, could come from a single relatively large investor or they might get $1,000 each from five different lenders. In either case, the borrower would see only one fixed loan. In the latter case, each investor would see a $1,000 note on their account representing their share of that loan.

Sites differ in how they evaluate individual borrowers and how they connect investors with potential borrowers. Most loans are small and personal, virtually all peer-to-peer sites have a low or mid five-figure lending cap. As a result they are typically unsecured personal loans often used for debt consolidation, although some websites will handle small business or auto loans.

How Does It Work for Investors?

For the investor, a typical peer-to-peer lending process works as follows:

• Select a website based on how well it fits your personal needs, evaluating data such as lending caps, interest rates and credit-check process.

• Create and fund an account. Websites differ in the minimum they require in an investor's account, but $1,000 is fairly standard.

• Select loans for investment. Investors who want to proceed manually can view loans based on borrower data including type of loan, purpose of loan, interest rate and credit score. Many sites show you a grade such as A, B or C rather than a specific credit score, and they assign interest rates accordingly.

• Or, set up automated lending policies. Rather than having to manage each loan individually, most sites will allow you to set policies by which your account will give out loans with metrics such as credit, type of loan, anticipated return and size of loan.

• Receive notes. A "note" is a common term among peer-to-peer lending sites. Since many investors can fund a single loan, each individual investor receives a note representing his or her share of a given loan. This results in the loan being diversified on the back end (the investors) while uniform on the front end (the borrower).

• Receive payments into your account or back to a bank account you specify as the borrower makes payments.

While the details will vary from site to site, this is generally how giving out a peer-to-peer loan works.

How Does It Work for Borrowers?

As with investors, each individual peer-to-peer lending website is different. Some will let you borrow more, others have minimum amounts you can borrow. The peer-to-peer site Upstart deserves particular note because it doesn't rely on a traditional credit check when evaluating borrowers. Targeted primarily at 20-something college graduates who may have little credit history, Upstart emphasizes factors such as education and employment when assigning a borrower grade.

For a borrower the process generally works as follows:

• Select a site based on how well it fits your personal needs, including overhead fees, interest rates and maximum/minimum lending policies.

• Create an account with personal profile information and authorize a credit check.

• Apply for your loan. The website will ask for information such as the type of loan you're looking for, in what amount and for what purpose. Many will have you write a short statement for lenders to read.

• Review loan offers and select the one which best fits your needs based on, among other factors, interest rate, payment plan and how much the site will charge for this transaction.

• Receive the loan into either your website account or a bank account you specify.

Advantages and Risks of Lending

The biggest reason for investors to participate in peer-to-peer lending is return on investment and the potential for passive income.

Peer-to-peer lending offers a mid-range return with a relatively low upfront capital demand. Across the industry, P2P lenders realize an average 4.4% return, making this considerably more profitable than savings account or many low-yield investments. Investors who give higher risk loans can push their yields to 10% or even 12%.

The downside is that the risk is not inconsiderable, and may be much higher than industry advocates claim. According to one research paper published by the Federal Reserve, and disseminated by outlets such as the Financial Times and Business Insider, delinquency rates are high and growing among peer-to-peer lenders. For 2012 and 2013 loans, (the most recent studied in the paper) delinquency rates approached 14%. However, that research paper, cited widely by credible institutions, has been rescinded by the Federal Reserve. Specific details as to why have not been forthcoming.

Peer-to-peer lenders have little or no protection against delinquency or default. It's why riskier loans pay higher returns. If a lender stops paying, you may simply lose the money altogether.

Advantages and Risks of Borrowing

The biggest reason to borrow is the same as to lend: access and interest rates.

While peer-to-peer lending is advertised for its convenience, that's a poor reason to select a financial product. However, what peer-to-peer lending does offer is cheaper access to money than many traditional financial products. Consumers who could not get a bank loan, or who could not do so affordably, can access peer-to-peer networks. And this product can be orders of magnitude less expensive than using a credit card.

In particular, research by University of Maryland Professor Michael Padhi has found that P2P lending significantly expands credit access among low-income and minority communities.

However, peer-to-peer lending can also magnify an individual's debt. Borrowers who start to use peer-to-peer services can find themselves trapped in debt cycles. Although the P2P industry aggressively advertises this as a way to get out of debt through consolidation, borrowers on average actually find that their overall debt levels grow by 35% over the lifetime of a peer-to-peer loan.

This is a particularly acute danger for anyone consolidating student or medical debt, or any form of debt which can come with legal protections. A consolidated loan will not carry over any of the legal or contractual oversight of the previous loan, meaning that a student lender who consolidates and then loses her job won't be able to defer any payments.