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Peer to Peer Lending Information: Consolidate High Interest Debt or Earn a Higher Investment Return

Updated on October 30, 2011

Peer to Peer Lending for Debt Consolidation or Investing

Do you have high interest credit card debt that you’re struggling to pay off? Are you an investor looking for higher returns than those available from bonds or interest bearing savings accounts? If so, peer to peer lending may be for you. In these tough economic times, it’s difficult for both savers and those trying to pay off debt. Banks are charging interest rates of 18% on credit card debt while paying less than 1% interest on the deposits of savers. Obviously this is good only for the banks themselves. Those who are trying to pay off their debts struggle to do so at those high rates and those who are savers aren’t making anything on their investments. Peer to peer lending has the ability to solve these problems but there are several things you should know before you jump into this either as a borrower or an investor.

What is Peer to Peer Lending?

Peer to peer lending is a form of lending that takes the middle man out of the equation by matching potential borrowers with potential lender investors. By eliminating the middle man, the borrower can get access to funding at lower interest rates while the lender can make a higher rate of return on his or her investments.

There are two main players in the peer to peer lending arena, Prosper and The Lending Club. Both operate Online, further reducing the cost. Both companies will evaluate potential borrowers and assign them a rating and a corresponding interest rate if approved for a loan. The lender investor can then choose which loans to invest in and will receive monthly payments on those loans corresponding to the amount invested.

How Are Potential Borrowers Evaluated?

The Lending Club, the industry leader, has a minimum credit score for borrowers of 660. After evaluating the credit score, the company will then look at the potential borrowers debt-to-income ratio. Excluding mortgage debt, the borrower must have a debt-to-income ratio of less than 25%. Finally, the potential borrower cannot have any negative items on their credit report from the past twelve months, must have at least three accounts opened in the past with two or more currently open, no more than eight credit inquiries in the past six months and utilization of their credit limit not exceeding 100%.

For borrowers who qualify, which The Lending Club says is less than 10% of applicants, a loan grade is assigned, along with a corresponding rate of interest. The interest rate is determined by the risk level of the applicant and could range from 6% to 21%. Repayment terms are either three or five years.

This is a great way for borrowers to pay off their high interest credit cards with a lower interest loan that has a specific repayment term. Borrowers will get a fixed payment and will have paid off their debt in a short time period.

What Should You Know About Peer to Peer Lending as an Investor?

Even though peer to peer lending is a great choice for potential borrowers, the benefits versus risk aren’t as clear cut for investor lenders. As a lender, The Lending Club touts an average rate of return of 9.6%, which is exceptional compared to what you could obtain in a money market account or bond fund. Unfortunately, that high rate of return comes with risk attached to it that anyone considering investing should be aware of.

First is the potential that a borrower might default on their loan. If a payment isn’t received from the borrower, no payment is made to the investor. The Lending Club says that they make every effort to collect on defaulted loans and is currently reporting a relatively low default rate of 3%. Unfortunately, since their platform is relatively new, the default rate could increase over time as loans age. Related to default potential is the fact that The Lending Club doesn’t verify income or employment for all loan applicants. A credit report is pulled for each applicant but income is taken at the word of the borrower unless The Lending Club has a reason to verify. Each loan with verified income is shown with an asterick on their website. Nor does The Lending Club monitor what the borrower uses the funds for. If the borrower doesn’t use the money to pay off their credit card debt then the risk of default could be higher.

Due to the risk of default, The Lending Club recommends that potential investors spread their investment across many loans, as many as 100-200 in some cases, depending on the amount invested. In this way, one default will not totally wipe out your investment and your average return will remain relatively high. The Lending Club can help you select a loan portfolio based on specified criteria or you can choose your own loans to fund. Borrower information is transparent, including the intended use of the money, making it easier for potential lenders to choose the loans they’d like to fund.

Another thing potential investors need to keep in mind is that The Lending Club charges a 1% fee on each payment to investors. This is pretty steep but because the interest rates are so high, investors still earn a good return on their investments.

Finally, it’s important to mention that if The Lending Club or Prosper go out of business, you may lose all of your investment. There are contingency plans in place to try to collect on outstanding loans in the case of a company bankruptcy but there’s no guarantee that the investor’s money would be a priority for payment.

The Bottom Line on Peer to Peer Lending

The bottom line on peer to peer lending is that it’s a great option for borrowers who qualify but investors need to be vigilant about risk. If you plan to invest in this type of vehicle, limit it to a small percentage of your portfolio and spread your risk by investing a small amount, typically $25-$100 in each loan. Peer to peer lending is revolutionary and has the potential to provide amazing benefits to both borrowers and lender investors. Just know what you’re getting into.


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