Peer to peer lending goes by many names. It is also called social lending, person-to-person lending or p2p lending. It can be defined in this simple way: individuals lending money to other individuals without a banking intermediary.
The official definition from Wikipedia is “a certain breed of financial transaction
(primarily lending and borrowing, though other more complicated transactions can be
facilitated) which occurs directly between individuals or ‘peers’ without the intermediation of a traditional financial institution.” Basically, it involves people with money (investors) lending to people who need money (borrowers). Obviously this is something that has taken place since the invention of money thousands of years ago.
Today, with the explosive growth of the Internet and online social networks, this concept has been brought online. So now, borrowers can borrow money from people they have never met and investors can lend money to many anonymous borrowers just based on their credit information. There are dozens of companies all over the world enabling peer to peer lending, and in the United States there are two established companies: Lending Club and Prosper.
There are also many companies that do what I call direct peer to peer lending (direct p2p). These are primarily for people who want to formalize a loan arrangement between friends and family. Companies in the U.S. doing this today are ZimpleMoney, LendingKarma, National
Family Mortgage and many more. They help setup loan agreements and manage the funding
process for you. While these companies provide a valuable service the focus of this e-book will
be on the mass-market p2p lending sites, Lending Club and Prosper.
I also want to make a distinction between peer to peer lending and microfinance. Microfinance typically deals with very small loans sizes (under $1,000) and are usually run by non-profit organizations. I am a big fan of microfinance organizations like Kiva (I loan money on Kiva) but they serve a different purpose and have different goals from peer to peer lending organizations like Lending Club and Prosper.
Why is Peer to Peer Lending Becoming Popular?
Peer to peer lending is a rapidly growing industry. In the 12 months ended December 31, 2014 the total amount of money loaned by Lending Club and Prosper was $5.98 billion. That is around 147% growth over the preceding 12 months. Clearly, it is becoming more popular all the time.
To understand why peer to peer lending is growing so fast, we need to look at the advantages it provides for both borrowers and investors.
Borrowers
The financial crisis in 2008 had a huge impact on banks and financial institutions that is still being felt. Many individuals who had found it easy to get loans from banks before suddenly found themselves cut off.
Many people had used the equity in their home to borrow money in the past couple of
decades, but with homes across the country dropping in value, banks became much more
cautious with this kind of lending. Unsecured personal loans from banks became almost nonexistent.
Many people who needed money found themselves resorting to credit cards with high interest rates. Clearly, there was a void in consumer financing and peer to peer lending helped fill that void. Borrowers found that their 28% credit card interest rate could be cut in half with a loan through Prosper or Lending Club. The fixed loan term, typically three or five years, is also appealing because borrowers can see how they can pay off their debt completely in a relatively short time period.
Investors
There are several advantages for investors. The biggest and most important one is the higher rate of return. Some Lending Club and Prosper investors are averaging at least a 10% annualized return, and the vast majority are earning more than 6%.
You can choose your level of risk with p2p lending. You can choose to invest in A grade loans where every borrower has excellent credit, where the likelihood of defaults are low. Or you can invest in higher risk, higher interest loans. Alternatively, you could choose some combination of these high risk and low risk loans.
Many people are drawn to peer to peer lending because you are investing in real people, not some faceless bank or mutual fund. Peer to peer lending also adds diversification to an investor’s overall portfolio. You are investing in consumer credit, which is a different asset class from other investments.
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