Peer-to-Peer Lending Breaks Down Financial Borders

Peer-to-peer (P2P) lending, also known as "social lending," lets individuals lend and borrow money directly from each other. Just as eBay removes the middleman between buyers and sellers, P2P lending companies such as Zopa and Prosper eliminate financial intermediaries like banks and credit unions.

P2P lending boosts returns for individuals who supply capital and reduces interest rates for those who use it, but it also demands more time and effort from them and entails more risk. Read on to find out more about this modern type of lending.

P2P lending is the product of vital business, technological and social trends, including:

1. A new generation of so-called "freeformers" who couple personal freedom with social activism. Freeformers want to take control of their work and leisure. Rather than work for one company for 35 years, they prefer to collaborate in networks for short periods on various projects. Freeformers are highly suspicious of large institutions; they believe in people, not banks.
2. The disintermediation of almost everything. Technological change, globalization and other international trends continue to reduce the number, size and role of business intermediates in many industry sectors.
3. The spread of web technologies, which foster "mass collaboration." These new tools enable individuals to work together online in huge groups to achieve mutual goals (Ebay and social networking sites like Facebook are examples).
4. The development of microlending to individuals with few assets in poor nations. Community- and social-minded lending entities, such as credit unions, have been around for a long time. But microlending gave impetus to the ideal of achieving social goals by making small loans to individuals. (For more, read: Microfinance: What It Is and How to Get Involved.)

Like most types of financing, there's lots of variety in P2P lending. Moreover, the legal issues surrounding P2P lending operations, especially in the U.S., are by no means settled. Questions remain about what kind of an entity a P2P lender is and which regulatory regime applies. Because of these concerns, the U.S. operations of foreign P2P lenders have sometimes strayed far beyond their original business models.

With these caveats in mind, here's how P2P lending works in a typical scenario:

You sign up and become a member at a P2P lender's website, and this lender acts as an intermediary (it does the recordkeeping, transfers funds among members, etc.). The lending company earns its revenue through fees charged to both lender and borrower.

Before you can borrow, the P2P lender performs several checks (personal, employment, credit, etc.). Standards are relatively stringent, and high credit risks can't borrow. After acceptance, you have two or more choices.

• The P2P lender will assign you to one of four or five risk categories, and you can borrow at the going rate for your risk category on that particular day; or
• You can have your loan auctioned to members with funds to lend. The lender/bidder sees the pertinent information you've provided on the P2P lender's site: the reason(s) you need the money, your financial history, your personal story, even something more personal, like a photo or a poem you wrote. You set an opening interest rate for your loan and accept bids; if the loan is fully funded, lenders can bid down the interest rate they are willing to charge to win the right to fund your venture. (For related reading, see: P2P Lending Sites: How Safe Are They for Borrowers?)

As a lender, besides bidding on individual loans, you can also choose to have the P2P company spread your funds among many borrowers. You decide the risk categories in which to lend; the more risk in your loan portfolio, the higher the return, but the greater the chance of default.

The major benefits of P2P lending for individuals are:

1. Lenders can enjoy returns several percentage points above those for a bank CD; borrowers enjoy similar cost advantages compared with rates at a bank or credit union.
2. Many individuals like knowing who they're lending money to and why they need the money. Not only does it give them a sense of personal satisfaction, but they can also choose borrowers who they believe will repay the loan in full and on time.
3. There's a charitable aspect to the lending. If a potential borrower has a dodgy financial history but a sympathetic story to tell, a lender can willingly choose to forgo a higher return and/or assume greater risk to fund the loan.
4. There can be a true sense of community at a P2P lender site. Forums tend to be active, and information is eagerly exchanged about lending and borrowing experiences. Proposed changes in the policies of the P2P lender are vigorously debated.
5. Some people just hate banks and will do anything to avoid using them.

Naturally, there is a downside:

1. Many borrowers are excluded because they do not have good credit. (For related reading, see: What Is a Good Credit Score?)
2. Lenders face exposure from defaults, and their funds (with some exceptions) are not insured. The success of P2P lenders to limit loan losses varies by lender and over time. A lender can be talked into making a bad loan with a good sob story.
3. Compared to walking into a bank or credit union, P2P lending can take much more work, especially if the loans are funded through auction. The loan selection and bidding process can demand a level of financial sophistication many people don't have.
4. Although returns to lenders may be higher than those on certificates of deposit, over time it's not certain they will be higher than those on a publicly traded index fund, which requires relatively little work to buy and hold.
5. Not everyone wants their financial story published on the internet; for those with some sense of personal privacy, the impersonal big bank has its benefits.
6. Because this is such a new industry, there are bound to be waves of lender consolidation, interface/administrative changes and changes to the lending practices themselves. This may be more of a burden and risk than disciplined investors are willing to allow.

Despite its drawbacks, P2P lending is gaining traction and seems certain to become more popular. There are P2P lenders in several countries, including Italy, the Netherlands, China and Japan, with startup operations in many other countries. (For related reading, see: P2P Lending: Yet Another Risk for Investors?)