Person-to-person loans (also known as peer-to-peer loans) are loans to unrelated individuals, or “peers”. This type of lending takes place without the use of a traditional financial intermediary such as a bank. Most person-to-person loans are unsecured personal loans, where the borrowers do not provide collateral as a protection to the lender against default.
The lending takes places online on the person-to-person loan company’s website, where the borrowers and lenders meet. The borrowers are required to provide their credit information, the purpose of the loan, the amount desired, and the loan duration. Interest rates are fixed by lenders, or are set by the intermediary company after an analysis of the borrower’s credit worthiness. The interest rates are competitive, and are often lower than those charged by banks and credit card companies. The loan terms vary, with most loans lasting less than 5 years. The rate of return for the lenders depends on the interest rate, the risk of default and the fee charged by the intermediary company. More risky loans carry higher interest rates and potentially higher rates of return. But due to the increased likelihood of default, the returns are much more volatile.
The intermediary companies are for-profit businesses, generating revenue by collecting a one-time fee on the loan amount from the borrowers, and by charging a loan servicing fee from the investors. These intermediary companies have lower operating costs compared to traditional financial institutions, allowing them to provide the service more cheaply, so that borrowers may be able to borrow money less expensively and lenders may be able earn higher returns compared to many investment opportunities. In the United States, there are two primary companies that facilitate person-to-person loans: Prosper.com and LendingClub. Prosper is the oldest of the peer-to-peer lending sites. It has less restrictive loan requirements, because of which, the loans tend to have higher default rates, but also provide better rates of return to investors. Lending Club is the current industry leader with over $2 billion in issued loans. It has stricter credit history requirements, due to which the loans are of higher quality.
Person-to-person lending comes with the risk of default because the lender has very little assurance that the borrower, who standard financial intermediaries may have rejected because of the lack of credit status, will repay the loan. Furthermore, peer-to-peer loan repayment in case of the borrower defaulting is not guaranteed by the U.S. federal government, limiting their penetration among big investors. However, the intermediary companies are increasingly using complex algorithms to better screen borrowers for risk, which should reduce the default rates.