Are Peer Loans Too Risky or the Way of the Future?

English: CML and Risk-free lending and borrowing

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If you haven’t already heard about peer lending, it’s likely that you soon will. The largest loan company, Lending Club, is getting ready to issue stock on the New York Stock Exchange and the media are already all over the story. Online lending has jumped over the last year. It took Prosper Marketplace eight years to originate its first billion in loans. The second-largest peer lending site originated its second billion in loans in just six months this year. Between the two lending websites, more than $600 million is being borrowed every month.

But are peer loans too risky for borrowers or is the market for online lending the way of the future?

Peer Lending Reborn

Around since just before the financial crash, peer lending got the same black-eye as all credit when the bubble burst on sub-prime loans. Five years later, heavy regulatory costs on community banks and limited growth in traditional lending are driving borrowers online and investors couldn’t be happier with the returns available.

The concept of peer lending couldn’t be simpler. A borrower fills out an application for an unsecured personal loan of up to $35,000 on one of the online lending sites which verify employment and other information. The application is posted to the website where investors choose if they want to invest in a portion of the loan, from as little as $25 each. If the loan is fully funded, the money is released to the borrower’s bank account and monthly payments are made directly to the website. The website handles processing, collection and passes payments through to the investors.

Rates for loans are competitive with personal loans from traditional banks. Borrowers with very good credit can get an APR as low as 6.7% while the average rate is 13% across all loans. In the past, most loans (80%) have been for debt consolidation. I talked to Ron Suber, President of Prosper Marketplace, last week and about growth in other loan types including: small business, home improvement, travel and medical expenses.

Online Loans, it Just Sounds like another Internet Scam

To be sure, there are risks for borrowers in peer loans but really no more than those risks in other types of debt. Credit is a tool in personal finance. Used properly, it can help you build your dream home and reach your financial goals. Used irresponsibly, and like any tool, it can smash your fingers something fierce.

The biggest risk to remember is that peer loans are not a solution to bad spending habits. Using a peer loan to pay off high-interest credit cards does not mean you can run out shopping and max out your cards again. This will only speed your fall down the debt spiral with double the debt. If you find yourself spending beyond your means and cannot help yourself, consolidate with a peer loan and ask your friends for a debt intervention to control your habits.

Don’t assume that because peer loans are unsecured credit, defaulting on a loan does not have big consequences. Peer loans are reported to credit bureaus and will affect your credit report just like other loans. Besides hurting your credit score, missed payments or a default on a peer loan will reduce your chances at getting another peer loan in the future. I know a lot of investors that will not loan to borrowers with a previous defaulted loan.

One of the reasons why peer lending has been so popular for debt consolidation is for the way the loan is reported on your credit report. Besides your credit history, credit bureaus look at the types of credit on your report to determine your score. Revolving loans, the debt with no fixed ending date like credit cards hits your credit score harder than other types of loans. Peer loans are reported as installment loans, like a mortgage, because they have a fixed ending date and fixed payments.

Despite being nearly a decade old, peer lending is still in its infancy and only a fraction of the overall consumer debt market. The industry has done really well in other countries like England and New Zealand and it will likely become a big part of the American lending environment over the next few years. Understand the risks to peer loans and you may just find one of your best tools in personal finance.

 


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