RENAUD LAPLANCHE is fortunate he had generous friends. Back in 1999, Laplanche was trying to launch a software company, and, as with many start-ups, financing it was a challenge. But Laplanche was a determined entrepreneur and even willing to use his credit card to cover some of the up-front costs, like a server and some furniture for his first few employees. The interest rate, though, was tough to accept. “I realized I was paying 18 percent on my credit card balance, despite the fact that I had pretty good credit,” he recalls. “I thought that was a very high rate.”
www.lendingclub.com) in 2006 to help facilitate availability of the kind of loan he received from his sailing buddies. “[With Lending Club,] people lend and borrow money directly among each other, and everybody gets a better deal,” he says. “Borrowers get their money at a better rate, and lenders get a good investment opportunity.”
A hybrid of social-networking sites (such as Facebook) and auction sites (such as eBay), Lending Club is just one of a number of what have become known as peer-to-peer lending sites, a group that also includes Prosper and Virgin Money. Their growth -- no doubt fueled by the housing crisis, which has made it impossible for many to tap their home’s equity for cash to start a business or to pay off credit cards -- has been brisk. Laplanche says the number of users at his site has been doubling every month for the past six months. Prosper has more than 600,000 users and has generated more than $100 million in loans.
The emergence of Internet-enabled peer-to- peer lending challenges the established, firmly entrenched control that financial institutions have long had over who can borrow money and who profits when money is lent. And that’s just what Chris Larsen, the CEO and a cofounder of Prosper, wanted. “The idea that a small group of institutions -- banks and credit card companies -- really controlled all the decision-making [around lending] sort of bothered us,” says Larsen, whose site also launched in 2006. “Everyone who loans money should potentially be able to fund a loan. They shouldn’t have to go to their bank passively, get paid 2 percent to 4 percent, and watch that bank turn around and lend [their money] out at 14 percent.”
ALTHOUGH THE SITES vary in small ways, the thrust of how they operate is basically the same. At Prosper, for instance, borrowers have to go through an initial screening process that allows the company to verify a person’s identity and evaluate his or her financial situation using data supplied by Experian, one of the three credit bureaus. Borrowers have to have a credit score of at least 520 to qualify, and Prosper assigns everyone requesting a loan a grade, which lenders can then use to assess the likelihood that they’ll get paid back. Once the borrowers have been accepted, they post a request for a loan amount, up to $25,000, along with an explanation of what they need the money for and, typically, a short description of how and why they will pay every penny back. Along with the amount requested, borrowers also note the maximum interest they’re willing to pay, which can vary depending on their credit worthiness and past history of loan repayment. Their information must also include their debt-to-income ratio and whether they own a home.
Lenders can search through pages of requests, which often are personalized with photographs and endorsements from friends, family members, and business associates. The majority of the loan requests on Prosper, which makes money by taking 1 percent to 3 percent of funded loans as well as by charging a small annual loan-servicing fee, come from people who want to consolidate debt to get a more favorable interest rate. But there are plenty of requests stemming from other reasons too. The results page of a recent search of borrower listings included someone looking for start-up capital for a bakery, a mother who wanted to purchase a computer so her daughter could study graphic design, and a guy who needed some cash to purchase an engagement ring (his loan was fully funded). Lenders bid to fund some portion of the loan and state the interest rate they want to receive. Like on eBay, bidding lasts for a set amount of time; when the time is up, a collection of the bids with the lowest rates are bundled into one loan. Once the loan contract is completed, money is automatically transferred from the borrower’s bank account to Prosper every month, in equal installments, for the standard three-year term of the loan. Prosper then distributes the money to the individual lender or lenders.
This lending process is drastically different from that of, say, the commercial loan office of a bank, where the only thing that matters is a financial institution’s profits. In peer-to-peer lending, factors beyond just the financial are taken into consideration when lenders evaluate borrowers. Madeline Smith discovered this last year when she used Prosper to get the $5,000 in seed money she needed to set up a pet boutique in her Brooklyn neighborhood. After she posted her request -- which was funded by about 100 lenders -- she received an e-mail message from a potential bidder.
“She asked me what had made me decide to do a pet boutique. To her, it was very exciting. And I told her that I’d decided that we needed one in Brooklyn,” recalls Smith, who used the money to renovate a showroom and purchase supplies for her newly opened store, Madeline’s Pet Clothier. Smith’s entrepreneurial dream obviously struck a chord with the lender, who bid to fund part of the loan. “Her response to me was, ‘You know what, it’s something I’ve always wanted to do, but I’ll live my dream through you.’ I never forgot that,” recalls Smith. “That touched my heart.”
While the sense of satisfaction that comes from being able to help another person is a motivation for some lenders, it is by no means the only, or even the predominant, factor involved. “Different people have different motives, but it seems that the number one reason, when we talk to lenders, is really to get a better-than-average return,” says Lending Club’s Laplanche, who reports that the site’s average annual return is 12 percent, far better than those of the stock and bond markets thus far in 2008. “It’s a good investment for them.” This rate of return, particularly in such an uncertain investment environment, has been enough to attract people willing to lend hundreds of thousands of dollars, as well as a few hedge funds and other professional investors. Some people even borrow money on the sites and then turn around and lend it to someone else at a higher interest rate.
NHAT NGUYEN was looking for a way to earn a better return on his money when he first stumbled across Prosper last summer. An educated investor who buys and sells individual stocks online and works for a Chicago-based hedge-fund administrator, Nguyen researched the site and ultimately decided that it was superior to other modes of investing. “Actually, this is a better way and a safer way to earn a good return -- an alternative to the stock market,” he says. At first, Nguyen would spend time reading through borrowers’ profiles, looking not only for people with a good credit grade and a willingness to pay the 12 percent return he sought but also for people he could help get out of credit card debt.
Lately, though, time has been too short to comb through borrower listings, so Nguyen has opted, as many do, to let Prosper do the bidding for him automatically. Like any savvy investor, Nguyen is careful not to bet too much on any one investment. Instead, he keeps his lending portfolio diversified as a way to reduce risk. “If you have $5,000, you don’t want to lend $1,000 to just one person,” he says. “You want to lend $50 to 100 people.” So far, it’s a strategy that has worked well. Of the 150 or so loans he’s provided, only two have defaulted. In those cases, the companies send the loans to a collection agency and alert the credit bureaus -- which hurts a borrower’s credit in the same way a missed Visa or mortgage payment does -- and prohibits the borrower from seeking more loans through the website.
Laplanche says Lending Club’s default rates are lower than the average numbers reported by the credit bureaus. He believes that is due to the fact that there is often a real human connection between lenders and borrowers in peer-to-peer lending. “At the end of the month, if you can only make one out of two payments and you know one payment is going to go to people like you, who trusted you, who lent you the money in the first place and are counting on that money, and the other to a credit card,” he says, “you are more likely to make the payment to the individual lenders.”
And that is exactly the attitude Smith has about repaying her loan. “I feel that if they went out of their way to lend me $50 or $100 or whatever, then doggone it, I’m going to make sure you get your money back,” says Smith, who now also lends money on Prosper. “That’s the personal connection.”