With faith in banks and credit card companies on the decline, more consumers are turning to social lending as an alternative to existing financial institutions for their borrowing needs. The worst offenders, credit card companies, have been lowering credit limits and increasing penalty fees and interest rates on even their most loyal customers. For this reason, frustrated credit card holders comprise one of the largest sectors looking into lending sites to refinance credit card debt. With interest rates as low as 7.8% at some social lending sites, 10% to 15% less than credit card companies and banks, consumers are giving this option a hard look.
One reason lending communities can offer such low interest rates, is because they operate only online. The higher overhead and operating costs associated with brick and mortar facilities are not there. These savings are then transferred to both lenders and borrowers in the form of lower service fees and higher returns.
Lending Club, one of the most popular person-to-person (P2P) lending sites, facilitates the selling of loans in the form of unsecured notes registered with the Securities Exchange Commission. The loans can be used for funding many of life’s necessities such as a baby on the way, buying a car, purchasing a home, paying off student loans or to cover medical bills. The site has become increasingly popular since 2007, mostly due to both the lending options it offers borrowers with various credit backgrounds and the investing opportunities it offers lenders.
Borrowers who might not be able to get a loan through a bank because of a spotty credit history may have a better chance of getting one through a lending site, although it will cost more in terms of a higher interest. Sites like Lending Club offer a range of possibilities for consumers with varying credit scores. Those who have a good credit score can expect to pay around 7.89% per loan. Borrowers on the other end of the spectrum can pay as much as 21%. All loans have 3-year terms. Borrowers can take out from $1,000 to $25,000 for higher credit worthy customers.
Investors who want to gain a higher return than a CD or a stock can earn on average 9.64% in annualized returns on these P2P loans. A service charge of 1% however, will be subtracted from the interest gained on the loan, reducing the note yield. According to Lending Club, if an investor purchases 50 notes each with an original principal amount of $200 and an interest of 8%, assuming all loans perform till term of 12 months without defaulting, the investor will get a net annualized return of 7.8%.
Fees imposed on borrowers for use of this service range from 1.25% to 3.75% of the loan amount depending on the borrowers creditworthiness. A loan grade based on credit history information provided by a consumer-reporting agency is applied to each borrower. The loan grade is then used to determine how much processing fees a borrower will be responsible for and how much interest they will pay on their loan. Collection fees are steep for borrowers who don’t pay back on time. Late payment fees start at 30% of a member loan if a borrower pays less than 60 – 90 days past due.
The way that interest rates are set is different among sites. Prosper.com for example, uses a bidding system where both parties determine the interest rate. Borrowers post the highest interest rate they are willing to pay for a loan and lenders post the lowest rate they will accept. When both lender and borrower concur on an interest rate, an agreement between the two is formed. According to Tiffany Fox, Communications Director at Prosper, the average estimated lender yield is 14.85%, average estimated loss rate (default) is 5.47% and average estimated lender return is 9.38%. Other sites are Loanio, Fynanz Inc. and Zopa.com.
Borrowers looking for a loan need to meet certain requirements before applying. For sites like Lending Club, a borrower must be a US resident, have a FICO score minimum requirement of 660 and a debt to income ratio (excluding mortgage) below 25%. Also, they must make available three years of credit history showing no delinquencies and no bankruptcies for the past 7 years, in addition to showing no more than 10 inquiries on the credit report for the past six months and a revolving credit utilization of less than 100%.
Lenders also have certain criteria to meet. As stated in their website, Lending Club lenders are required to be a resident of the states listed on their site, they must have an annual gross income of at least $70,000 and a net worth of at least $70,000 excluding home, home furnishings and automobiles or have a net worth of at least $250,000 with the same exclusions. Residents of California need to have an annual gross income of at least $100,000 and a net worth of $100,000 with the same exclusions or a net worth of at least $250,000. The site restricts individual lenders from making loans of more than 10% of their net worth.
What happens if a borrower doesn’t pay back the loan?
For investors, lending to borrowers through these sites provides a good opportunity for those looking for a moderately high return, but it does come with risk. Investors might lose part or all their money if a borrower defaults on the loan. In cases of default, the lending company will try and recoup some of the money but there is no guarantee they will get it back. Some lending sites will work out a new payment plan with borrowers or in more severe cases; send the loan to a bill collector.
There is also the risk of lack of transparency. Some borrowers might not be completely forthright, holding back certain facts about their credit history if this will diminish their chances of obtaining a loan. Lending sites try to obtain as much background financial information possible but there is no check system in place to completely prove the validity of information provided by borrowers. However, interested lenders can directly ask borrowers questions through the site. Some questions might be about their background, employer, why they are requesting a loan and with what income they plan to pay the loan back.
Investors can also spread the risk by obtaining a variety of loan notes rather than focusing on one loan from an individual borrower. For example, since the minimum note size is $25 for most sites, an investor can loan out $100 in $25 notes to 4 different borrowers as a way of increasing risk diversification. Funding several borrower accounts instead of one will enable a lender to considerably decrease their default exposure.
Lending sites might be the answer to those looking to borrow money or invest some funds. For investors, it’s important to look carefully at how each site determines the interest rates for the loans and what fees they will charge. Fees can cut into the yield of a loan’s return. Also, invest only funds you can do without if you lose all of it, remember this is a numbers game.