Peer-to-peer lending is where you borrow or lend money to another individual instead of dealing through a bank. With normal banking, savers deposit money (i.e. they are lending it to the bank), and the banks then lend the money out to borrowers. In other words, the bank is the middleman, making a profit by borrowing cheap from savers and lending high to borrowers. Peer-to-peer lending cuts out the middleman entirely, which means that lenders should be able to get a higher interest rate than if they had saved the money in a bank, and borrowers get a lower interest rate than if they borrowed from a bank.
So how does it work? Borrowers and lenders are matched up via online networks such as The Lending Club and Zopa. The rules vary – Zopa performs a credit check on the borrowers, and then lists them along with the blurb the borrower writes describing their situation, allowing the lender to select the borrower directly. Borrowers are charged a small flat fee for using the service and lenders are charged a 1% fee for using the service, and Zopa handles all the collection and distribution of money. The Lending Club operates slightly differently – they bundle the borrowers into groups based on credit scores and lenders lend to each group based on criteria they specify about the type of risk they take. The lenders don’t have as much personal detail about the borrowers as in the Zopa system, so they can’t select individual borrowers. Again The Lending Club handles all the collection and distribution of money and charges a 1% annual fee for this.
So what are the benefits? In these times of credit crunch and recession, where the banks are gouging on interest rates to try to claw back profits, peer-to-peer lending can save borrowers a lot of money, especially if they are a good credit risk, as they will get a keener interest rate than they would have at the bank. For small businesses, peer-to-peer lending can be a lifeline, especially as the big banks are arbitrarily cutting off credit lines even to businesses that are solvent and profitable.
From the lender’s point of view, you make the profit that a bank would have by lending out the money. However before deciding to loan money like this, potential lenders need to make sure they understand the mechanics of risk management and credit scoring. As with all lending, there is a proportion on loans that will go bad. You need to learn how to set the interest rate to reflect risk, and also how to tell a bad risk in the first place. For those who are intelligent and willing to do their homework, this can be very profitable indeed.