Recently I stumbled upon the world of P2P (peer-to-peer) lending. Just like P2P downloading is when users upload and download from each other without the usual intermediaries, P2P lending allows individuals to borrow and lend from each other without a traditional financial intermediary (read: a bank). Not having to deal with a bank could be a big win for both the borrower and the lender. How?
Let’s look at a simple example of two guys, Frank and Dave. Frank has $20,000 in credit card debt at a 20% annual interest rate, so he pays $4,000 in interest per year. Frank has good credit so he applied for a $20,000 loan from his local bank. The bank approves the loan at a 15% interest rate, and Frank uses the loan from his bank to pay off his credit cards. Now Frank’s credit cards are paid off and he owes the bank $20,000 at a 15% interest rate, so he only pays $3,000 in interest per year, coming out $1,000 ahead.
Dave has $20,000 to invest. He signs up for a 3 year CD at his local bank that pays 1.5% interest annually. Dave makes $300 in interest per year on his CD.
What P2P lending sites such as Lending Club and Prosper do is cut out the middleman, the bank. Borrowers like Frank apply for loans on these sites, and the sites vet them and decide if they are credit worthy (Lending Club is fairly strict in its requirements, less than 10% of borrowers are accepted). Then, the site selects an interest rate appropriate to how much credit risk the borrower has. Say a borrower has had defaults, a low FICO score, and a high revolving credit balance. This borrower will have to pay a higher interest rate on their loan because they represent a higher risk to lenders.
Now suppose Frank applies to Lending Club for his loan instead of his local bank. Because he has good credit, Frank gets an interest rate of only 10% on his $20,000 loan. Now instead of paying $4,000 in interest to the credit card companies or $3,000 in interest to the bank after refinancing, Frank only pays $2,000 per year in interest to Lending Club (who then pays the individual lenders who decided to fund the loan on the site).
Dave sees Frank’s loan on Lending Club and decides to fund the whole thing. Now instead of earning only $300 in interest per year using a $20,000 CD, Dave earns $2,000 per year on interest (however, unlike when Dave invested in a CD, Dave now has risk of Frank defaulting on his loan). If Frank does not default, both the borrower and lender come out ahead by foregoing the bank.
Of course, this is a pretty big oversimplification. In reality, lenders like Dave greatly diversify the loans they invest in P2P lending. The minimum that can be invested in a loan is $25 on Lending Club and often lenders invest that amount in every loan that passes their requirements. In this case, if Dave invested his $20,000 he would be part of 800 separate loans. Indeed that’s one of the biggest draws of these P2P sites, the ability to quickly and broadly diversify across loan types. Lending Club boasts that 90.36% of Lending Club investors with over 800 notes earn between 6% and 18% on their investments. The average return has been 9.64% since the start of the site, including defaults (more on defaults in next week’s post). This average return is pretty high and one of the biggest factors that drew me into P2P lending.
Because I have extra cash on hand, I’ll be looking to join P2P lending on the investing side, not borrowing. However, if I needed a loan I would definitely apply to these sites and compare their interest rates against banks.
Next week, I’ll look at the risks and rewards of P2P lending and why I chose Lending Club over Prosper (even though I’m very happy to have competition around).
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