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Is Person to Person Lending Safe?

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I received several reader e-mails this weekend regarding the safety of person to person lending. I thought I would share these questions and the answers, so hopefully more people will better understand the process.

Regarding Person to Person lending – do you know how they underwrite these loans? Do the borrowers have to provide credit scores? Can a non-payment show up on their credit report?

I like the idea, but I could see this blowing up. While I certainly don’t like how the credit card companies go after folks who don’t pay, it does tend to force compliance. What does Prosper do if folks default?

~ Kirk

Kirk, thanks for the question. I will break apart your questions below and explain the lending process, and how the P2P lenders make the process as safe as possible for everyone involved. I will use Prosper as an example, but Lending Club is very similar.

The Person to Person Lending Process

The lending process is set up just similar to a financial institution providing a personal loan to an individual. The loan is a legal loan and is reported to the major credit bureaus and there are collection agencies in the event of a default.

Borrower ID Verification: The borrowers provide all their financial information including SSN, date of birth, address, telephone number, and a bank account for verification. They also provide income level and profession. This info is used to verify the borrowers ID against anti-fraud and credit databases. Prosper does a full credit check to determine credit scores. On top of that, Prosper has a 100% guarantee against identity theft to protect borrowers and lenders alike.

Defaults: If a borrower defaults on a loan, it is reported to the major credit agencies and there are established collection agencies to go after the money for the lenders. A loan from Prosper or Lending Club is a legal loan, just as if it originated from a brick and mortar bank.

One small difference – Lenders aren’t actually lenders. The loan is actually made by Prosper with their own operating funds when enough “lenders” have agreed to fund the loan. Once Prosper makes the loan, the “lenders” buy pieces of the loan. I put the word lenders in parenthesis because they are not actually lending money, they are buying a piece of the loan that Prosper made. At this point, you become a lien holder. The term lender is used because it is easier to identify with.

The P2P Loan Process is Safe

The loan you are purchasing is really no different than a bank underwriting an unsecured loan to another person. Security and verification measures are put in place, the loans are reported to and tracked by the major credit agencies, and in the event of a default there are collections agencies to help recoup your investment.

While the process is safe, there is risk involved. These loans are unsecured and not guaranteed. They have the same risk that a regular financial institution takes when they make an unsecured loan to an individual. However, the interest rates charged by the peer to peer lending companies are designed to offest the risk.

I invest in person to person loans

Right now I have several loans with Prosper and Lending Club. I am only investing funds that I can afford to put at risk. Just like any other investment, you need to do your research to determine the level of risk you are willing to assume and the percentage of your portfolio you are willing to invest.

The best way I have found to lend is to do your research to determine which borrowers might represent a low risk loan – generally someone with a high credit score and a low debt to income ratio. While the loan isn’t guaranteed, the returns can quite possibly be better than a CD or high interest bank account.

Try Peer to Peer Lending for little to no risk on your part

If P2P lending intrigues you, now is a great time to try it out with little to no risk on your end.

Prosper is also giving new lenders $25 to sign up, but you have to fund a loan before you get the bonus, and the minimum loan is $50. So, it will only cost $25 to try the lending process. Prosper also has a referral program, so you can again refer people and make money. Keep in mind the bonus is not paid unless the person you refer either makes a loan or borrows money.

Lending Club has currently placed their referral program on hold. Check back later for more details.


Published or updated February 27, 2011.
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{ 13 comments… read them below or add one }

1 lulugal11

I love the idea of person to person lending. I am both a lender on Prosper and a borrower on Lending Club.

I have a good credit history and I wanted to get a loan to pay off credit cards that have high interest rates. My banks and credit unions did not offer me a low enough rate to make it attractive..but Lending Club did.

My payments of my loan are current and the income from the small loans I made are also current.

This is a great idea and I encourage people to try it out. At the very least just use the bonus money they give you to fund a loan and then you can do more later.

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2 Jose

I do believe in person to person lending.
I have a small $5000 portfolio in prosper.
Hopefully it will keep doing well – no defaults yet.

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3 Ryan

Kirk, You’re welcome. I think the process is set up well, it is just a matter of being able to accept the amount of risk you are willing to take when funding a loan.

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4 Ryan

lulugal11, Thanks for the comment! I don’t know very many people who have used Prosper or Lending Club as a borrower, but I am happy to hear this has worked well for you. :)

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5 Kirk

Ryan,

Thanks for the thorough response. This really explains how these groups work. Again, I love the fact that lending is being democratized; I just wanted to ensure certain safeguards were in place.

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6 Ron@TheWisdomJournal

Hey Ryan,

Is there a referral program? If I do this, could you get the credit? Given your very thorough blog post, I think you SHOULD get some credit 8)

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7 Mrs. Micah

Like any investment, I think one of the best ways to be safe is to diversify your loans. $50 max per loan, for instance, won’t bankrupt you if it’s not fully repaid. And of course there’s such a variety of risks, just like in stocks.

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8 Ryan

Ron, yes, there are referral programs for both Prosper and Lending Club. The links in the article above are my referral links. Each person who meets the requirements will get a $25 bonus for signing up, and I will get a referral bonus as well. Once someone is a member, they can refer other people as well. It is a very easy way to try out the system with little to no risk on your end, and possibly make more money in the process. :)

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9 Ryan

Mrs. Micah, the low minimum investments are one of the aspects I like about person to person loans. They are easy to fund and easy to spread your risk among several loans. :)

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10 CiaranFromChance

If I ever start to advertise on my site, I think I will support the peer to peer lending. It’s a very interesting concept that seems to be catching on like wild fire on a lot of PF blogs.

I’m going to give it a shot soon.

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11 Ryan

Adfecto, The default rates are terrible if you make sub-prime loans; loans to highly rated borrowers have extremely low defaults. The impetus is on the lender to do his or her research.

I agree, the companies are young, but the business plan is solid. If the companies fold, there are credit agencies that will take over the loans. If they are bought out, I imagine the loans would stay in place as they are. They are legal documents, and so far as I know, they are not subject to change at someone’s whim.

I don’t agree that there is a conflict on interest by having affiliate links within the post. I have neither stated these companies or loans are guaranteed, nor have I stated you should blindly invest in them. I have always stated to do full research before investing. The fact that the companies are offering sign-on bonuses to new lenders and the people referring them is the kind of free money many people are looking for. In fact, anyone can sign up with Lending club and get a $25 bonus without being obligated to make a loan. What’s wrong with free money?

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12 Adfecto

The default rate is terrible. The fees are high. The companies are young and unstable; what happens to the loans if Prosper.com goes under or is bought out? I will wait on the sidelines until there is a proven track record and the returns justify the risks (neither are true right now).

Your affiliate links and attempt to drive traffic to the lenders should be viewed as suspect by readers as well. It is a conflict of interest that you should disclose right off the bat in your post.

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13 Adfecto

@ Ryan

I have no problem at all with affiliate links. By all means monetize your blog to its fullest potential. However, I prefer to see a disclaimer either near the link or in the initial paragraph of the piece that discloses the advertising and affiliate relationship. I just worry about a post “Is It Safe” and then concluding with “try with no risk on your part.” I do think that gives the wrong impression or is at least confusing.

About defaults, I have read in other sources that the collection agencies used by Prosper have a poor track record of recovering funds from bum borrowers. These companies also take a fee for their service. When there is a default you stand a very good chance to loose most of your money. Even AA loans loose 1.75% of their return to defaults (A – 4.76%, B – 7.45%, C – 10.78%, D – 10.58%, and E – 16.52%). With these kinds of defaults you are fighting uphill for every dollar you get. In order to diversify enough to get these average rates and be sure not to just loose 100% of your investment, you should fund about 100 loans for every one you think will go bad. To invest in AA you should fund 175 loans at $50 each ($8750) to smooth out returns to get close to the average. Obviously this goes up dramatically as you go down in credit worthiness. When you get to D credit grade you should fund 1058 loans at $50 ($52,900) to spread your risk correctly to loose ‘only’ 10.58% of your APR. With small amounts your APY will differ greatly from your coupon because the returned capital can not be easily reinvested if it is small amounts. If you loan out $50 it will take forever to get back enough profit and principle to make another loan so you money sits in Prosper earning no return. You loan out $50 for 3 years to an A borrower at an 11% rate. After fees and assuming you don’t have a default (with is a 1 in 20 chance) you will find that your annualized return is only about 4.5%. This is because of fees and because an average half of your capital was actually sitting on the sidelines. If you have a massive amount you could fund a new loan (or a few) each month from your returned capital so your yield would actually approach the coupon (which is the amount of interest most lenders THINK they are getting paid) value.

Now to address performance. When it is all said and done 8.14% from an AA borrower or 6.95% from an A borrower (net fees and defaults) is not enough return to justify the risk. There are corporate bonds from companies like Ford, JP Morgan, Royal Bank of Scotland, and MGM Mirage that pay better than 6.95%% and they are backed by real assets. As you move lower down the credit scale it gets even worse. There is nothing securing a Prosper loan beyond a credit score and harassing phone calls from a debt collector. You see my point?

Anyway, this turned into a phone blog-post as comment. I’m probably going to post it over at my blog now. I haven’t proof read and things aren’t perfectly explained but I hope you now have a picture of what a mediocre (at best) investment peer to peer currently represents.

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