Person to Person Lending

In the past, investors that were looking to add a fixed income component to their portfoliowere forced to choose between certificates of deposit, savings bonds, government paper, money markets, corporate bonds, commercial paper, or bond funds. Now, thanks to a few enterprising financial institutions, a new model has emerged in the fixed income field that holds the potential to turn the industry on its head.

It’s called person to person lending and the idea is actually thousands of years old. According to Propser.com, the leader in person to person lending in North America and a company created by the cofounder of industry giant E-Loan, the practice began in China circa 300 A.D. and today is known in many countries under different names such as Lun-hui in China, Gameya in Egypt, and Tanda in Mexico. By creating an electronic platform, it and several other competitors in the field, have created a means for investors to make (and request) loans.

The Theory Behind Person to Person Lending

The theory behind this system is that it matches up lenders who would like to earn a rate of return noticeably higher than they can achieve at their local bank and borrowers who either don’t want to deal with the hassle of a bank or are looking for ways to get funding for projects that would otherwise have a hard time earning approval from the local branch manager.

How It Works

An individual signs up for an account and submits their personal information to the company which then runs a credit check and assigns a credit rating. Once the process is completed, he or she is able to both request and make loans. An illustration may help.

Imagine a single mother, Mary, wants to raise $10,000 in cash for her home-based candle business. Her bank won’t approve a loan because the operation isn’t big enough and her credit cards will charge her 20%+ interest so she wants to find an alternative. In this case, she could create a listing at Prosper and say, “I’m interested in borrowing $10,000 and want to pay less than 12% interest.”

Once the listing is posted, other individuals (people like Mary) could then review her request, see her credit rating, and examine how she plans on using the funds. They could then place a bid in a reverse Dutch auction – in essence, Joe, a firefighter from Minnesota could say, “Of that $10,000, I’ll loan a total of $200 at 13.50%.” Penelope, a Doctor in New Jersey could say, “I’ll loan $1,500 at 12.25%”. Once the auction ends, the software platform used by Prosper will take the most advantageous bids to Mary and create a single loan that she will be able to approve to determine if it meets her needs. Assuming everything goes well, the winning bidders (lenders) will have the money taken out of their bank account and consolidated. Prosper will then write a loan to Mary based on the winning bids, and deposit the proceeds into her checking account, less a small percentage fee in exchange for the service.

At the time of this writing, all loans are written on a three year term. Each month, the required payment is deducted from Mary’s checking account and split on a pro-rata basis to the lenders which will receive a monthly deposit to their bank accounts until the loan is entirely paid back.