The Problems With Peer-To-Peer-Lending
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
– Shakespeare, Hamlet
I’ve spent the last couple months researching the prospects of peer-to-peer lending. When you’re investing for financial independence, you’re interested in any asset class that beats inflation. If you’ve reached financial independence, then you’re thrilled to find a new source of passive investment income! If you “need” money, then P2P borrowing like a great way to cut through all that stuffy financial bureaucracy to borrow real money from real people just like you. P2P seems interesting when you can lend money at rates that beat today’s low yields on bonds and CDs. P2P is downright compelling when your lending generates a stream of nearly passive interest income from a diversified portfolio.
The sector has executed its current business model for roughly five years, and in the last year it’s made a lot of progress. (It’s also been getting a lot of media attention.) If you’ve never even heard of P2P lending before then this post is going to give you a very broad overview of the process and its issues. Afterward I’ll send you off to other websites to investigate the nitty-gritty details of “how” and “where” to get involved.
If you’re following the press about P2P lending, and especially if you’re a customer, then this post is going to add a few links to the subject and focus on “why” you’d want to get involved. Or not.
Bottom line up front:
If you’re borrowing from a P2P lending company then you may already have a serious debt problem and need to change your financial habits. This is a good place to get out of debt but it might be your last chance. It’s time for a major lifestyle change or the next step could be a personal bankruptcy.
If you’re investing in P2P lending then you need to understand our human susceptibility to a number of behavioral-psychology delusions. The concept is extremely attractive but the risks are not easily perceived, let alone quantified. You will almost certainly lose some principal, but your yield should exceed those losses. However you may not be adequately compensated for your capital at risk.
Speaking from my three decades of unrelated investing experience, P2P lending seems like juggling chainsaws. Eager crowds will pay you a lot of money to do it, and if you do it with hard work & skill then you could end up rich– but if you get greedy or have bad luck then you might also end up with the nickname “Lefty”.
Before I get into the details, let’s look at the big picture.
The borrowing process
The traditional finance industry offers two basic choices for borrowing money: collateral or no collateral.
“Collateral” may be your home, a real estate investment property, your vehicle, your money on deposit with a bank, or your shares of stock held by a brokerage. If you can’t pay the interest or principal on your loan then the lender is eventually allowed to seize your collateral. If you’re willing to provide collateral to your lender, then you’ll get a lower interest rate. The more collateral you can offer (and the higher your credit rating) then the lower your interest rate– even as low as the car dealer’s “zero percent”. This is also known as non-recourse debt because the lender can only take your collateral and can’t come after your income or your other personal assets. A typical non-recourse loan is a home mortgage, and current rates on long-term mortgages are around 3-4%.
In my opinion, collateral is a very good thing. It gives the lender the confidence to loan you money. It also gives borrowers a limit. You’re rarely going to be able to borrow more than your collateral is worth, and it’s usually a major decision. Before you take out a $20K car loan (or a $350K mortgage) you’re going to do some serious analysis and consider whether this is really a good idea.
If you can’t (or don’t want to) provide collateral, then you’ll pay a higher interest rate. This loan is “unsecured” because there’s no collateral for the lender to seize. However the lender still has a “recourse” loan that allows them to pursue your income or your other personal assets. If you default on the loan (by missing a payment) then the lender could sell your loan to a professional collection agency, or take you to court to obtain a judgment against you, or otherwise attempt to shame motivate you into paying up. However the lender’s most practical alternative for a defaulted unsecured loan is to report it to a credit-rating agency that will trash your credit score. Even worse (from the lender’s perspective) a defaulted borrower could declare bankruptcy so that the lender would lose all recourse– and get nothing at all. Lenders are willing to take these risks because they’re lending relatively small individual amounts to a widely diversified group of borrowers at high interest rates, and defaults are relatively low. The classic example of an unsecured recourse loan is a credit card, and interest rates range from 6% to well over 20%.
Credit cards are the classic example of the bad things that can happen without collateral. Credit-card applications are a lot easier than car loans or mortgages. Heck, the lender may even pay you to take their credit card! You don’t have to make a major decision before you borrow the money– you just whip out your card and buy stuff. It’s way too easy to carry a balance and never pay off the loan, and it’s even easier to let the loan build up to a six-figure debt.
Borrowers aren’t the only examples of bad loan behavior. The finance industry is heavily regulated and scrutinized, yet the 2008-09 financial crisis showed just how far lenders can stray off the path before the market realizes there’s a problem. Collateral for non-recourse loans (real estate) turned out to be wildly overvalued and lenders were extremely leveraged on debts (mortgages) that turned out to have very poor chances of repayment (high default rates). Lending went bad so quickly that the system froze up and nobody was willing to lend to anyone without high-quality collateral. The federal government spent hundreds of billions of dollars to prop up the industry with cheap loans (in exchange for shaky collateral) until the leverage could be unwound, and five years later it’s still not over. Keep this liquidity issue in mind when we later discuss these startup lending companies whose business is “only” in the hundreds of millions– just a fraction of a percent of the “traditional” finance industry– and whose loans are completely unsecured.
Outside of the traditional finance industry, borrowers have a wider range of choices. Pawnshops are happy to lend you money on collateral (because they hold it for you until you pay them back). I buy a lot of bargains at pawn shops, which gives you an idea at how successful their borrowers are at repaying their loans. Casinos are happy to lend money to their biggest losers customers. The military is all too familiar with a wide variety of “payday loan” companies who typically want their money back by allotment from your next paycheck. (You indenture yourself to them with your own labor as collateral.) There’s also an interesting variety of “independent contractors” popularly associated with illegal gambling or organized crime. These lending institutions may have a shady reputation, but they’re all still heavily regulated and scrutinized. (I should also point out that despite their criminal reputations, they’re not the ones who nearly locked up the country’s financial system with the bad behavior of excessive leverage and irrational exuberance.) Most borrowers are discouraged from tapping these sources of funds, and I’m not going to consider them a practical source of loans.
[Let me re-emphasize that last paragraph for you military readers: do not use payday lenders. Peer-to-peer lending offers a better alternative than payday lenders. P2P loans are not your best choice, but they’re far better than payday lenders.]
Finally, you can almost always find a friend to lend you money (at least for the first loan) and when all else fails there’s the Family Bank of Mom & Dad. Compared to all the other lending sources, these two may be particularly attractive sources of cash because they’re not bureaucratic institutions and they’re relatively willing to support you with a little fast cash.
The challenge of these last two alternative lending institutions is that they still depend on your reputation, whether that’s by credit check or by birth. When you “crowdsource” a loan from friends & family then you still have to persuade them that you have a good use for the funds, and that you’ll be able pay them back. The challenge is that you may have to contact a dozen people before you’ll find anyone willing to loan you money, and they probably won’t give you all the money you want. After you’ve phoned up a crowd then you may be discouraged enough to go back to an institutional lender.
But wait– what if the Internet could connect you with thousands of new contacts who were willing to lend you money while cutting through all the stuffy banker’s bureaucracy? What if borrowing money was as easy as eBay, PayPal, and Craigslist?
Borrowing from your peers
Most of the above lenders are trying to run a business and make a profit. When they issue a loan, they’re putting capital at risk. If they can’t hold your collateral (or grab it back) then just a few defaults would wipe out their profits and put them out of business. (And if you default on a loan from your friends or your Mom, then pretty soon you’ll be out of business.) The capital risks mean that the lenders have to charge a high interest rate to offset the occasional defaults.
But what if the lenders could sell your loan to someone else? Now they don’t have any capital at risk. They could continue to service your loan by collecting your payments and distributing them to the people who bought your loan. The mortgage industry does this all the time by selling your loan to other financial institutions who want to market loans as mortgage-backed securities. Mortgage companies still have to check your collateral and set up a non-recourse loan, but that’s regulated by the foreclosure process. They don’t have their own capital at risk anymore, so they can hypothetically offer you a lower interest rate.
Now what if the lending company could cut out most of the lending expenses? If they could lend money at lower rates then they’d get more borrowers. If they could sell high-yield loans to investors then they’d get more lenders. The trick is to charge borrowers a lower interest rate than a credit-card company (less than, say, 25%/year) while paying investors a higher yield than most bonds (more than, say, 10%/year). If they get rid of all those pesky collateral requirements then the interest rates are even better and they reduce their business expenses even more. By cutting out most of the expenses (and all of the middlemen), the company could eke out a profit and then grow the business.
Over the last decade, peer-to-peer lending companies have been re-building the loan-servicing business model. If you want to borrow money from them then you still have to fill out an application. You have to offer personal information and agree to a credit check, and perhaps you have to supply more documentation for verification. In exchange, the P2P lending company guesses decides how likely you are to repay your loan and what interest you should pay.
Then, before they even give you any money, they see who wants to buy your loan. Just like eBay, they throw your loan application up on their website for their eager lenders to bid on it. Lenders have barely enough financial information about you to entice them to lend you money while not actually knowing who you are or where you live. They don’t really have to care because they’re doing this with hundreds or even thousands of borrowers.
I can only imagine how complicated & painful this business model must have been to create. For example, the financial institutions that buy mortgages are willing to tie up their capital for nearly three decades. Unfortunately there aren’t many individual investors willing to tie their money up in a seven-year CD, let alone a 30-year mortgage. If a peer-to-peer lender holds the loans (or lends the money for too long a term) then the government regulates them as a bank. If they sell shares in the loans then they could be treated as a company selling shares of stock and regulated by the SEC. If P2P lenders charge too much interest then nobody will want to borrow money. If they charge too little then investors won’t buy their loans. They have to charge fees for their business to make a profit, but if they charge too much then someone will inevitably find a way to undercut them. Above all else, the company has to scale: it has to reach a critical mass of customers in order to make the business worth building, but then it has to be able to handle millions more customers at very little cost.
How P2P lending works
Luckily for the P2P lending industry, the cost of developing a Web-based financial business has dropped tremendously over the last decade. A few brave (or incredibly optimistic) entrepreneurs managed to raise enough seed capital from even braver (or more deluded) investors to build a website and the business process. Then they started recruiting customers.
When you decide to borrow money, you sign up with the P2P lender. You promise not to lie and you give them enough personal info for them to run a credit check on you. Your credit score and your income could be the only justification for the interest rate that they offer you, or you could volunteer more documentation (tax returns, employment verification) to persuade them to lower the interest rate a little more. (Or maybe they don’t want to waste their time & money on verifying your documentation.) For various legal and cost reasons that have been worked out over the last decade, your loan term is only 3-5 years. This short term means that your monthly payments will be a lot higher than you’re used to seeing from mortgage banks and credit-card companies. The annual interest rate on most loans will be between 6% and 35%. The maximum amount that most P2P companies will give you is $35,000, but if you’re a typical customer then you’re probably seeking $5000-$15,000.
The P2P lender uses an automated process to set the interest rate on your loan. It’s a complicated algorithm based on default probabilities, statistical history, and lender experience. It’s difficult to develop and it costs a lot of money to build. (Hopefully it’s cheap to maintain & tweak.) But let’s be honest here: it’s sophisticated guessing at your default risk and how much interest you’re willing to pay. It’s a mathematical model that may only overlap reality by 99%, and we all saw what happened in that 1% area during the Great Recession.
As a borrower, you’re getting a recourse loan with no collateral. You agree to pay the principal & interest on schedule, as well as any late fees. If you default then your credit rating will be trashed, your credit score will drop by over a hundred points, and your loan will be turned over to a collection agency. The collection agency will pursue you and might even seek a court judgment against you. (That’s the “recourse” part of a recourse loan.) If you’re in the military, a loan default makes you a security risk. The only legal way you can escape the collection process is to declare bankruptcy. Of course bankruptcy also has a devastating effect on your credit history (and your security clearance), but hopefully you’ll work out a repayment plan with the collection agency– or possibly even be completely excused from paying the loan. Good luck with that.
The “peers” who lend you their money are hypothetically capable of understanding (and affording) these risks. They have to agree to the lending company’s rules and qualify to be their lenders. They’re getting a much higher yield on their capital than they’d earn in most stock or bond markets, so they may decide that they’re being adequately compensated for their risks. The vast majority of them are only going to lend you a little bit of their own money: typically $25-$200 per person. The lenders do this to spread their own capital among a widely diversified set of borrowers so that they’re not hammered (too badly) by defaulting borrowers. This means that your loan will only be funded if enough suckers volunteers step forward to supply the cash. From what I’ve read, there are plenty of eager volunteers.
The lending company has their own fees. They’ll collect a funding fee from the borrower of 1%-5% of the loan amount, but that’s deducted when the money is sent to the borrower. They collect a processing fee from the lenders of 1% on the payments. Notice that until the loan is actually funded and the borrower starts making payments, the lending company is working for free. They don’t get anything up front, and they only make money if the lenders agree to fund the borrowers. If the borrowers are late on payments then the lending company can collect additional fees, but late-paying borrowers have an unsettling tendency to become defaulted borrowers.
Before you borrow
From a borrower’s perspective, the P2P companies and the lenders are both eager to lend you money. Really, really eager. They’re so eager to lend you money that you should worry a little about why they’re being so nice to you. A future post will tell you why there are so many enthusiastic peer-to-peer investors & lenders out there, and why P2P may still be a much better deal for a borrower than for a lender.
If you’re thinking of borrowing money from a P2P company, first you have to address a bigger problem: Why are you willing to pay high interest rates for a no-collateral (unsecured) recourse loan?
The answer is simple: You’re spending more than you earn. You want to stop doing that.
I completely understand if you’ve been hit by a big medical bill or an unexpected car repair or a large emergency travel expense. I empathize if you need to borrow money to adopt a child. However in the first case you can negotiate far better payment terms with the hospital than with a P2P lender. In the second case your car could serve as collateral for a cheaper loan. In the third case then you might be able to borrow from friends or family before approaching a P2P lender. If you’re adopting a child, I applaud your altruism– but you should save as much money as you can before the adoption in order to pay for the greater expenses of raising your family. And after you recover from these situations, you should build up an emergency fund to help soften the financial impact from a future crisis.
If you’re in the military then you have other options. You could negotiate a repayment plan with the debtor, especially if they’ll accept an allotment from your paycheck. You could seek assistance from a military relief organization, including debt counseling & consolidation and even possibly an interest-free loan. If you’re facing extra expenses for a transfer then you could get an advance on your pay or on your travel claim.
If you want a P2P loan to start a business, then maybe you’re doing it wrong. Go find some customers and get them to front you a little money to solve their problems. Go find an incubator to coach you in return for a little of your equity. If you’re solving the right problems then you don’t need a P2P loan. If you’re solving the wrong problems then you need a different business model. If you need to grow your business (because it’s already successful) then read more about angel investing at VentureHacks.
If you’re trying to pay off your high-interest credit-card debt with a lower-interest P2P loan, then be very careful. A P2P loan will be for a much shorter term, so even if you’re paying a lower interest rate then you may still be paying higher principal payments. In addition, credit-card debt happens when you spend more money than you earn. If you get a P2P loan to pay off the debt, you still have the problem of spending more money than you earn. You may need to stop using your credit cards and possibly even seek financial counseling. Otherwise a P2P loan is just adding a second problem and helping you spiral ever deeper down the debt toilet toward bankruptcy. The next post will compare P2P loan payments to credit-card payments to help you choose your option.
If you’re seeking a loan for a vacation or home improvement or an engagement ring or a wedding (as encouraged by P2P company websites), then you need to re-think your priorities. To be blunt, you earn the pleasure of these experiences by saving up for them. Show some commitment to yourself and your significant other: cut your expenses and save for these goals.
If you’re still considering borrowing P2P money, then use a loan calculator to check your payments. Remember that these are short-term loans, so they’ll absorb a significant chunk of your paycheck. The next post will list the major P2P lending parameters and supply a calculator for you to estimate your payments.
There. I’ve tried to talk you out of it. If you insist on borrowing P2P money, then only do it once. Get out of debt, cut your expenses, build an emergency fund, and get back on track to build your net worth. But if you can do that, then the next post will also show you how to do it without a P2P loan.
If you’re still keen on borrowing from a P2P lender, the two biggest U.S. companies are Lending Club and Prosper. Lending Club does not offer loans in Iowa, Idaho, Maine, Mississippi, North Dakota, Nebraska, or Vermont. Prosper does not offer loans in Iowa, Maine, or North Dakota. (Maybe these states are on to something? The website roster varies occasionally from the company’s prospectus, so check those links before you apply.) I’ll update this post as the situation changes, so let me know what your state does to approve P2P lending.
Prosper even targets the military for specific loan purposes, but you should check rates with both companies. Once again, if you’re in the military then you have better options to pay for military-related expenses. You’re also protected by the Servicemembers Civil Relief Act (see the link below).
Before you borrow, please read my upcoming posts on estimating your loan payments and on why lenders are so eager to throw money at you.
If you’re a lender, then please keep your wallet in your pocket until you read the next two posts.
3 June 2013 update: Here’s the second post, which reviews P2P loans from the borrower’s perspective and includes a calculator to help decide whether the payments are affordable.
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