Peer-To-Peer Lending

Peer-to-peer lending, which is sometimes called social lending, person-to-person investing, or P2P lending, is the financial practice of making loans between unrelated people (peers) while avoiding banks and other traditional financial lending sources. Peer-to-peer lending is conducted online with intermediary platforms that use a variety of underwriting and credit-verification methods along with software to bring borrowers and lenders/investors together. In the U.S., Prosper and Lending Club are the two largest competitors in this niche. The SEC has allowed both entities to market portfolios of notes secured by the loan payments to be received; there is also a secondary market for these notes, which offers liquidity for investors. The majority of P2P loans are unsecured loans to individuals without any collateral, although an increasing number of peer-to-business loans are also being provided, and in some cases these business loans are secured (collateralized). Interest rates for peer-to-peer loans are typically set in one of two ways: The rate may be decided by the lender, typically by using a reverse-auction platform so that multiple lenders compete to provide loans at the lowest rates to the most-qualified borrowers; or, the rate may be set by the intermediary platform itself, based on a credit-scoring analysis of the individual borrower. Although “offline” P2P lending among family and friends has existed for thousands of years, the development of the Internet and computer technology has allowed the wide reach, diversification, and technical streamlining of the underwriting process necessary to offer loans far beyond local geographic communities. P2P lending platforms have lower overhead expenses than bricks-and-mortar banks because they lack physical offices and require fewer staff, so borrowers may benefit from lower interest rates while lenders may receive higher returns. These platforms generate their revenues through the fees collected from borrowers, which are typically one to five percent of the loan amount. Recently, the leading peer-to-peer lending platforms have begun to securitize pools of P2P loans for sale into the secondary marketplace, which may provide an additional measure of stability for lenders and investors.

Who uses peer-to-peer lending?

Borrowers often turn to P2P lending platforms after first seeking loans at traditional banks, whether because of credit denials or due to unpalatable interest rates available through conventional banks. As well, the demand for peer-to-business loans and e-commerce financing is increasing, and the intermediary platforms are developing underwriting, credit-scoring and loan-servicing processes to address the market for small-business loans. Most peer-generated loans are dedicated to personal or household purposes such as school expenses, home repairs and vehicle purchases. As of 2012 in the U.S., the median loan was said to be slightly less than $10,000. Wiki Because of recent changes in U.S. law under the JOBS Act, securities issuers including online lending platforms can now solicit investors directly through broad sources such as the Internet and social media. Beyond the retail lenders/investors who have fueled the growth of these platforms to-date, accredited investors are now also pouring money into peer-to-peer lending. Disenchantment with low returns from retail savings accounts has long attracted relatively small investments from retail lenders/investors; now sophisticated investors and institutions are increasingly seeing the advantages of peer-to-peer loan portfolios over other, more-sophisticated debt investments.

How does it work?

As with traditional lending through financial institutions, P2P credit-scoring is based on analyzing creditworthiness in order to predict the likelihood that a particular applicant may default, and then either declining the applicant or offering appropriate credit terms. Unlike traditional loan underwriting, P2P lending platforms' due diligence often includes an assessment of the borrower's online presence and credibility as verified through social media. Peer-to-peer lenders also differ from traditional lenders because they select individual borrowers from across a diverse selection of prospective borrowers available through the online platform, instead of limiting themselves to a single geographic area. Also, online lenders further diversify by lending smaller individual amounts, yet to a larger number of borrowers.

Potential risks

Since P2P lending is not heavily regulated like banks and other traditional lenders, person-to-person lenders' investments are not guaranteed by the Government-- If the intermediary platform suffers a bankruptcy or if the platform fails to accurately qualify prospective borrowers, then the lenders' investments may be at risk. Of course, since most person-to-person loans are unsecured, defaults are a primary concern for lenders/investors in the online lending niche. According to some news reports, during the 2009 to 2010 period defaults on three-year P2P loans rose to an average of thirteen percent, although independent analysts typically cite an annual default rate of between one to six percent. At least one online lending platform has reported their average default rate at only three percent, which compares favorably with the credit-card industry's benchmark default rate of 3.6%. Diversification helps investors spread their risk. Many lenders/investors focus on making loans averaging $25 per borrower, with a portfolio composed of hundreds or even thousands of borrowers, all managed with appropriate software. In any event, the intermediary lending platforms have continued to work to improve the underwriting process and reduce the default rate; nowadays, the platforms are said to reject approximately ninety percent of all applicants based on due diligence, and lenders/investors are also able to access borrower information in order to verify income and home ownership before deciding to lend. Reuters

Returns, and other benefits for investors

From independent retail investors to hedge funds and large institutions, investors of all kinds are flocking to peer-to-peer lending. They are attracted to the high yields and short terms: Most peer-generated loans have maximum terms of three to five years, and the expected returns are said to range from six percent up to as much as thirty-five percent. Still, according to various news reports, the average return for successful investors seems to be in the range of ten to twelve percent, which is often better than the returns on other alternative investments, and can also beat the return on equity investments. Likewise, the stability of returns from P2P lending also appear less variable than the returns on equity investments. Financial Times All in all, person-to-person lending deserves a closer look by investors in search of suitable debt investments.