Peer lending, which has been made popular by services such as Prosper does have its benefits as well as its problems. Whichever side of the equation you happen to find yourself on, either as a lender or as a borrower, you need to make sure that you understand the risks of using such a service.
What is Peer Lending?
Let’s start with what peer lending actually is – it’s a way of lending money (or borrowing money) in a non standard way. The idea is that you can choose to lend out money to people who may need it and make more money from your investment than you might make if you were to invest in more traditional options. Similarly, those who need a loan may be able to get cash this way whereas they may not be able to get a loan from a bank or some other traditional venue. In theory then, this concept allows for a win-win situation where everyone gets what they want.
The Downside of Peer Lending
The downside of peer lending is mostly on the side of the person doing the lending, though there is a downside for those who are borrowing money as well. For those doing the lending, the big problem is that there are no guarantees that the money will be paid back. In fact, Prosper at one point actually shut down operations temporarily because they had so many loans going bad – especially after the housing bubble burst and the Great Recession began.
Borrowers Don’t Get Credit Ratings
The bad side for borrowers is mostly that they won’t get a credit rating with the big three credit bureaus because of the fact that peer lending is not really a traditional sort of a loan. This means that those hoping to rebuild their credit will see little benefit from using a service such as Prosper (though they can still get their loans of course).
You Need a Good Story
Another issue for borrowers, again a more minor one than the problem that lenders have, is that they are not guaranteed to get a loan from a peer lending site. Many such sites do have ratings for their prospective borrowers, allowing lenders to choose those whom they feel are most likely to pay loans back or to choose those who are higher risks and who will thus be forced to pay higher interest rates for their loans. However, in addition to the ratings, a second component of many peer lending sites is that the person asking for a loan needs to be able to articulate why they need the loan and needs to have a good “story” to tell. Otherwise, they may not get funding, especially if they’re considered a poor risk.
Best to Diversify
Investors wishing to make money through peer lending sites should consider diversifying in order to minimize their losses. Choose one or two loans which are for amounts that you can afford to lose and where you feel comfortable with the borrower’s story and credit rating. Then, make the loans and wait for them to be paid back before re-investing the money. This way, if the loans do go belly up, you only lost what you could afford to lose and not money that you needed for vital things in life, like retirement saving.
George Gallagher is a finance and education blogger who works with students to find private student loans to fit their college needs.
- The Hidden Extras of a Loan (2009tax.org)
- Small Business Loans Just Got Better (fastswings.blogspot.com)