Borrowers Circumvent Banks with IOUs: Peer-to-Peer Lending Is on the Rise and SEC has them Towing the Line

As the name implies, peer-to-peer (P2P), also known as social lending or person-to-person lending, entails a financial transaction in which an individual borrows money from another, as opposed to going to a bank or credit union. Unlike the “good” old days when one may borrow money from a friend or family member face-to-face or by telephone, many engaging in this alternative lending process are utilizing the Internet.

No surprise there, but what may be surprising is that Celent, a research and advisory firm, predicts that by 2017, $5.8 billion will be made in the United States. That is nearly an 800 percent boost in the market. The notion that individuals can borrow and loan money to each other seemingly creates a win-win situation for the parties involved. Those who are especially grateful, for this apparent blessing, are households strapped for cash and small businesses. As it enables credit worthy applicants to borrow up to $25,000 at an interest rate that’s slightly higher than those offered at the Bank.

So who is in the forefront of earning this mulla, sites like Lending Club, Loanio, and Pertuity Direct—to name three. Although each has adjusted their models to comply with The SEC in an effort to avoid the same fate as Prosper, a leading P2P lender, these companies’ top executives remain optimistic about the future of the “IOU” lending option as do some industry experts.

The Founder and Chief Executive of Lending Club, Renaud Laplanche sees registration with the SEC as a means to foster the company’s credibility and its transparency. He says, “There’s a general sense of maturity in the space that comes out of [the process]. It made it possible for us to establish a secondary market for the loans to give lenders the ability to sell a loan if they need liquidity for any reason.”

Why is P2P lending gaining steam?

  • Lenders get a fixed return.
  • Borrowers get competitive interest rates.
  • Lenders can earn returns that are several percentage points higher than a bank CD.
  • Borrowers can obtain loans with or without collateral based on their financial situation.
  • Intermediary institutions get a piece of the pie based on the spread between the lending and borrowing rates.

What do the experts say?

Although, some economic experts have criticized P2P lending for granting to few loans to fill the gap left by the collapse of asset-backed securities. P2P lenders claim they are a responsible lending vehicle trying to ensure their businesses do not meet the same demise of traditional financial services companies. That said both Lending Club and Pertuity require prospective borrowers to have a minimum FICO score of 660.

Michael Kalscheur, a financial consultant at Castle Wealth Advisors says that he is impressed with Lending Club’s reputation for declining most loan applicants, because it means “that Lending Club protects the investors from bad apples who are likely to increase defaults and lower everyone’s profits.” As of now, Lending Club has made more than $33 million in loans and has rejected loan requests equaling nearly nine times that amount.

Laplanche expects the company to process upward of $350 million in this year and believes the P2P market will develop into a billion dollar market in two years.

Becoming a P2P borrower.

According to Investopedia, prospective borrowers should sign up and become a member at a P2P lender’s website. The P2P lender, who serves as an intermediary/lending vehicle, will keep records of the transaction and transfer the funds. The intermediary earns its revenue by charging fees to both the lender and borrower. The standard fee rate is in the neighborhood of approximately 0.5 percent of the loan.

The borrower submits an application and the P2P lender performs a background and credit check. Those with poor credit scores will be rejected. However, once an application is accepted, the intermediary gives the prospective borrower a risk rating. The borrower is then given an amount in which they may borrower based on their level of risk.

Acceptable borrowers may also auction their loan to the lending members. The bidder sees the applicant’s pertinent information published on the P2P lender’s site. The borrower sets the opening interest rate price for the loan and accepts the bid of choice.

Becoming a P2P lending member.

Interested parties can become lending members of the P2P sites. They make money by spreading their funds among borrowers. Lenders decide how much risk they are willing to absorb. Much like the traditional banking, the greater the risk, the higher the return, and the greater the chance of default.

Conclusion

P2P lending is a relatively new financial business model in the US, but it’s proving that it has sticking power as it remains steady in an economy that continues to sink further into a recession. As long as individuals need a helping hand and small businesses need funding, P2P lending is certain to reap the fruits of its stronghold on the age of grassroots lending.