By PATRICIA SABATINI
Pittsburgh Post-Gazette
Monday, October 08, 2007
Anyone who's ever lent a chunk of money to a relative or friend knows it can be a murky proposition fraught with sticky questions and daunting problems.
How much should you lend? Do you charge interest? If so, how much is fair? How long should the borrower get to pay it back? Then there's the unpleasant task of reminding a dawdling dear one that payments are due, not to mention the realization that your "loan" has morphed into a gift.
Enter the so-called peer-to-peer lending business, an emerging arena of financial Web sites that help arrange and manage loans between family members, friends and -- as whacky as it may sound -- total strangers.
The sites all work a little differently, but were founded on a common principle of cutting out the middle man, which helps borrowers get a lower interest rate than they might through traditional sources such as a bank or credit-card issuer.
Instead of making money on the interest rate spread, the sites take their cut solely through fees for arranging and servicing the loan.
At Prosper.com, a San Francisco-based site launched in February 2006 by the co-founder and former chief executive officer of online broker E-Loan, Chris Larsen, borrowers post how much money they're seeking (from $1,000 to $25,000) and the top interest rate they are willing to pay. Potential lenders bid to finance an entire loan, or more typically, pieces of loans. The bids with the lowest rates win.
Prosper collects an origination fee from the borrower ranging from 1 percent to 2 percent of the loan and an annual servicing fee from the lender of between 0.5 percent and 1 percent of the outstanding balance.
The company collects and disburses monthly payments on the loans, which are all made for three years.
"Clearly there is a market for this," said Greg McBride, financial analyst with Bankrate.com, which tracks consumer finance rates and trends.
Borrowers are turning to the sites as an attractive alternative to high-rate credit-card loans, payday loans and other small unsecured loans that many banks won't offer, he said.
Lenders -- basically anyone with a spare $50 -- are attracted by the prospect of earning higher returns than they may get elsewhere, such as in a bank CD.
At Prosper, borrowers go through a credit check and get guidance about what to put in their listing, which must include their credit rating. For example, they may want to note any colleges they attended, which could sway a fellow alumnus to offer a better interest rate.
Lenders and borrowers are given market benchmarks to help them set and choose rates.
People can chose to lend to only the most highly rated borrowers and accept a lower interest rate, or make riskier loans to boost their returns.
There's no limit on the amount someone can lend -- several people have lent more than $1 million, Larsen said -- but the company recommends people minimize risk by lending in $50 to $100 increments to a diversity of borrowers.
"It's early in the history of Prosper, so defaults are still fairly small, but we would expect them to come up over time," he said.
Investors should expect typical market default rates of around 1/2 percent for borrowers with the best credit ratings up to about 15 percent to 20 percent for those with the poorest scores, he said.
Another peer-to-peer lending site that arranges loans between strangers, Zopa.com, which was launched in Britain in 2005, has said it plans to begin operating in the United States later this year.
McBride of Bankrate.com said people considering lending their money through peer-to-peer sites should understand the risks.
The big one, of course, is defaults.
"It doesn't matter how great the rate is; if someone is not paying you, you aren't making any money," he said.
Prepayments also can erode returns if the investor is unable to quickly re-lend the money at a similar rate.
For borrowers, "Understand that if you default on a loan, they hire a collection agency to track you down and collect the money," McBride said.
"This is not a free lunch. You have to make your payments, just like you have to make the house and car payments every month."
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