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Are Person to Person Loans Guaranteed?

by Ryan Guina

I recently received a reader question about Peer to Peer Lending, and I would like to share the answer with everyone.

Prosper and Lending Club have become very popular. Are Person to Person Loans guaranteed?

First, let’s address the popularity of P2P lending: Prosper and Lending Club have become popular because the P2P lending process gives people another option for lending and borrowing money. The lending and borrowing process bypasses banks. The advantage of these loans is that they can offer borrowers a lower interest rate and give individual lenders the opportunity to lend to individuals and potentially earn more money than they could earn in a CD.

Now, to answer the main question: The short answer is no. The rate of return is not 100% guaranteed. However, the P2P lending process is safe in that it has a defined lending process, is a legal loan, and is reported to credit agencies.

The lending process: The process works very similar to a financial institution making an unsecured loan to an individual. The borrower’s ID and financial history is verified, their credit score and history is investigated, and their debt to income ratio is determined. From this information, the lenders assign a base interest rate for the loan. The risk is similar to the risk a bank assumes when they underwrite an unsecured loan to an individual.

Prosper agrees to fund the loan on the condition that enough “lenders” agree to buy the loan from Prosper when it is funded. So actually, the “lenders,” people like you and me, are buying a piece of a legal loan that was made by a financial institution (in this case, Prosper).

Lender Protection: Once the loan is made, the borrower pays the funds to Prosper, which then doles out the payments to the lenders. If a payment is missed, late fees are assessed to the borrower. If the loan goes into default, it goes against the borrower’s credit report and there are collections agencies to collect the money. Skipping out on a P2P loan has the same consequences as skipping out on a personal loan made by a financial institution.

So no, the loans are not 100% guaranteed, just like an unsecured personal loan from a financial institution to an individual is not guaranteed. But it works exactly the same way and has the same consequences to the borrower.

If the loan isn’t guaranteed, then why lend through P2P Lending? The P2P Lending process allows individuals to “be the bank,” and have the opportunity to earn more money than they could otherwise earn in a savings account or CD. Prosper and Lending Club make their money by taking a small cut of the final loan value and other service fees. When it works properly, everyone is happy – borrowers get a better rate on their loan, lenders get better interest rates on their investments, and the P2P company takes a small cut from each loan.

There is risk involved. As with any investment, you should do your research before investing. Some P2P borrowers are people with very high credit scores, and low credit risk. However, that does not mean the loan is a guarantee. Other borrowers have very poor credit scores or history, and the interest rates are usually higher as a result. Lenders are assuming the same risks that banks assume when they make an unsecured loan to an individual.

Protect your investment: The best way to protect your investment is to make informed decisions on which loans to fund, and to diversify your loans by spreading your investments among several borrowers. Loans can be made through Prosper for as little as $50, and through Lending Club for as little as $25. This makes it much easier for lenders to loan small amounts to a.) more easily fund loans with a small initial investment, and b.) diversify their loans to decrease the risk of any one large investment going into default. With P2P lending, diversification is paramount.

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.

$25 Sign-up Bonus from Lending Club: Lending Club is currently offering new lends a $25 bonus to sign up for a lending account.


Published or updated March 2, 2009.
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{ 10 comments… read them below or add one }

1 Dividend growth investor

I would be interested in getting more information about the screening criteria that most prosper lenders are using. I myself stay away from bidding on loans that involve ” lender seeking to reinvest in prosper” or listings which show an individual with a perfect credit score willing to finance for over 15%.

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2 Ron@TheWisdomJournal

I’m still figuring it out myself. I put it $50 and selected a portfolio. It says my interest rate is 11.5%. That’s almost the S&P average over the past 80 years! If this thing works out well, I’ll be putting in a lot more.

On risk, where do you get 11.5% without some risk? There’s too much demand for “guaranteed returns.”

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3 No Debt Plan

P2P lending still makes me nervous. There are collection agencies, but usually they buy the debt for pennies on the dollar. Spread the loan over 100 people and you aren’t looking to get a lot at the end.

I may try it some day, just not today.

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4 Ryan

No Debt Plan, I understand. The loans are by no means a guarantee. However, I think there is promise in the fundamentals, so I am giving it a shot. However, at this point and for the foreseeable future, P2P lending will only be with money I can afford to take a little extra risk with. This is my “Mad Money.” Instead of playing the stock market or going to the casinos, I have a limit and that is all I am using. It’s much safer than placing it all on red and watching the wheel spin around! :)

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5 Morgana, a curious potential borrower

From what I have read so far this sounds like something that could benefit and work well for both the Lenders and the borrowers. That is if this system really does work. I am curious if the borrowers that really need the help from this the most will be able to get a loan? Considering that a lot of the people applying would probably have low credit scores and or high debt to income ratio. I wonder if the companies take these factors into consideration and therefore lower the bar when it comes to a borrowers qualifications or if these loans are just as difficult to get and therefore no help to the people who really need them. A lot of the people that whould benefit from this are just people going through hard times but really want to work on and fix the situation they are in.

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6 Ryan

Morgana,

Yes, this is something that can help both parties. Borrowers often get better rates than they would from banks, and lenders often get better rates by lending to individuals than they would from a CD or similar investment. When it works properly, everyone wins.

The borrower’s credit score, debt to income ratio, and other factors are certainly considered and I’m sure there are some people who do not get accepted for loans because of this. However, there are many people who have reported being able to get loans through P2P lenders such as Prosper even after several banks have turned them down.

I think a small loan from a P2P company such as Prosper is a great way to improve your credit score.

I mention Prosper several times, because right now that is the best option in the US because Lending Club has temporarily cut down drastically on their lending to new borrowers. Prosper also has a reputation for giving borrowers with lower credit scores more loans than other companies.

Whether or not you decide to go this route and apply for a P2P loan, I wish you the best and hope you are able to improve your credit score and make good things happen! :)

*As a disclosure, I sometimes write for the Prosper Blog.

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7 Jan

Can Canadians invest in this?

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8 Ryan

Jan: Lending Club is the only company currently offering to sell notes to new lenders (Prosper has gone into a quiet period while they file paperwork with the SEC).

For Lending Club, I believe you need to be American because you need a Social Security Number; from their FAQ page:

If you are an individual and want to lend through Lending Club, you must be at least 18 years old and have a valid Social Security number and successfully pass our identity verification mechanisms.

You may try contacting them for verification.

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9 Ed

I’m looking for a long term mortgage secured by seasoned commercial real estate with an income stream in Salt Lake City.

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10 Morgan Perry

I have been investing $50/month in Prosper and so far I have had zero problems. It sure does build my savings faster than any old bank account would. I am choosy about the personal story and apply some “street smarts” here and actually feel I am doing something positive in the world.

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