Last Updated: July 1, 2008
It sounds like a marriage made in heaven. On one side, there are people who are struggling with debt who can't qualify for lower rates from conventional lenders or credit card companies. On the other, there are folks with a few thousand to invest who might like to get a higher return than they'd get in CDs or money market funds.
It's a new trend in Internet-driven finance – peer-to-peer lending. Aided by Web sites that create matchmaking opportunities between people with money to lend and those who need it, peer-to-peer lending essentially makes private loans happen between strangers online. Sites like Prosper.com – the current industry leader – allows prospective borrowers to supply the details of why they need the loan and why and what they're willing to pay, and lets prospective lenders review their qualifications based on their overall creditworthiness and "bid" on that borrower's business.
Prospective borrowers – mostly younger people who already make social networking an everyday activity – even put their pictures next to their loan requests.
Is this a good idea? It could be for borrowers and lenders who can't find better alternatives and are willing to mutually honor their agreement. But keep in mind that such arrangements are a big step removed from conventional lending, and for that reason, there are particular things you should know going in. Among them:
There's no guarantee that a lender will be repaid: If any site promises 100 percent, on-time repayment to prospective lenders, walk away. They simply can't promise guaranteed payments or returns. Conventional banks can't guarantee full repayment of the money they lend, so how could an online site do it? If you decide to participate as a lender, your first objective is to consider risk. Think about it – if you've bought stock in a company that goes out of business next week, the value of your investment may shrink to zero. Lending or investing money entails risk – you have to understand how much you can safely take on.
There's no way to guarantee that a borrower or a lender may be who they say they are: While verification policies and procedures vary at different lending sites, Prosper.com promises users it will work with law enforcement to track down borrowers who acquire loans through fake identities and promise to make lenders whole for the amount they've had stolen due to proven identity theft. Keep in mind that doesn't provide a guarantee for anyone who skips payments on a loan, and recent reports show that many peer-to-peer loans have significant late payment or default rates.
You need to be confident your own information is protected: Keep in mind that you're surrendering your name, address, credit and Social Security information to this third party to verify your identity and creditworthiness. Even if they've been in business awhile, make sure you understand what protections are in place to make sure your critical financial data is protected.
You need to understand how late payments are handled: The peer-to-peer lending site keeps the payment records, and it should report any late payments or other irregularities to the three credit reporting agencies. At the same time, make sure there are no prepayment penalties – any borrower should be free to prepay their loan ahead of time.
Watch issues that could affect your credit score: Reputable peer-to-peer lending sites will only report credit activity on loans that have been originated, not when a prospective borrower creates a listing. That means if you apply for a loan and there are no takers, that shouldn't impact your credit rating.
Watch how the site mitigates lender risk and borrower advantage: At Prosper.com, you'll notice that each proposal has a little measurement bar that indicates what percent of the loan has committed bids. That bar indicates the number of potential lenders who have stepped up and agreed to fund a portion of the loan at a rate somewhere under the maximum the borrower is willing to pay. That's important. First of all, that indicates that there will not be one lender, but several, meaning that a single lender wouldn't be on the hook for the whole amount. The borrower gets the advantage of multiple bidders willing to lower their interest demand in exchange for the business.