Partners (Number 2, 2008)

Peer-to-Peer Lending: A Tool for Community Finance?

Most of us wouldn't dream of asking our neighbors for a loan to consolidate credit card debt or buy new equipment for our business. But what if you knew your neighbors were looking for someone to lend money to?

This describes the concept of peer-to-peer (P2P) lending, which allows borrowers and lenders to transact business without traditional intermediaries such as banks. This approach, also known as "social lending," is a growing trend both in the U.S. and around the world, and it could have important implications for financing community development.

Expanding niche draws lenders and borrowers
As global credit markets tighten to create bottlenecks in available bank lending, the social lending niche market is beginning to expand its structure and pick up participants. While P2P lending cannot eliminate the inherent risk of credit, the simplicity and ease of this system are attracting a growing market segment willing to experiment with a promising alternative to traditional loans and investments.

"While P2P lending cannot eliminate the inherent risk of credit, the simplicity and ease of this system are attracting a growing market segment willing to experiment with a promising alternative to traditional loans and investments."

Social investment is also drawing donors who want to direct their donations personally to causes they believe in. Direct personal investment makes it possible to track the impact of projects on individual communities and lives. Harking back to the "character loan" of bygone days, this investment trend has at its heart social capital—what each of us uniquely brings to the table.

The Internet facilitates expansion of peer-to-peer financing by providing a medium that supports communication, analysis and accounting. Prosper.com based in San Francisco and Zopa.com in Britain are two services that match people who need to borrow money and people interested in lending money.

For a fee, the online services arrange person-to-person lending and provide safeguards and services on both sides of the transaction. These sites and others offer a variety of lending models and platforms, product structures and levels of communication between participants.

Who user P2P?
Chris Larsen, CEO of Prosper.com, one of the internet companies that provides a peer-to-peer lending infrastructure, describes the company as an eBay for lending. "We view our role as that of the infrastructure that provides a tool for this marketplace," says Larsen. He says that many Prosper.com members who lend are looking for both a financial return on investment and the opportunity to do something good for their community.

In the marketplace model for peer-to-peer lending, organizations like Prosper.com connect borrowers and lenders through a competitive process: borrowers present loan opportunities and lenders bid interest rates and terms on the loans that interest them. The average Prosper.com transaction is an unsecured loan for $6,000 with a three-year term. Larsen says Prosper.com's original goal was to offer an alternative to high-priced unsecured credit cards.

The typical Prosper.com borrower tends to be 35 to 55 years old with an average income of $50,000. The borrowers are generally split evenly by gender and are geographically dispersed throughout the country. "Lenders tend to skew younger," says Larsen, "with an average income between $50,000 and $100,000."

Lenders are often motivated by more than just the higher returns offered for smaller investment commitments. The social benefit is also attractive to many who are willing to take risks with a relatively new and unproven process. As individuals, the lenders are applying unique decision criteria to selecting potential borrowers for funding.

Larsen says that when the company started, roughly two years ago, subprime borrowers with less problematic credit histories accounted for nearly 25 percent of the organization's lending activity. Now, subprime borrowers make up only about 5 percent of the lending portfolio. Borrowers with strong credit are finding they can save about 3 to 5 percent on interest with a P2P debt consolidation loan. The company has generated over $125 million in loans and has a current default rate of 4.7 percent.

Lending circles could benefit community development
One interesting feature of the P2P industry is the potential to form lending circles or groups—both as borrowers and as lenders. The group can comprise individuals who interact closely or a broad membership that mirrors the structure of credit unions. Lending performance within groups can enhance credit references for individuals or can create references for members through group performance. One example of such a group would be an alumni association.

Larsen says that lending communities on Prosper.com can also improve the loan bids offered to borrowers when fellow group members personally vouch for a member or make bids on the loan requests. He says that loans to those who have received the endorsement of friends or have received part of the loan from friends or group members tend to have lower default rates.

Based on this experience, it seems possible that neighborhoods or nonprofits could establish lending groups to support community revitalization or help local businesses grow. A neighborhood revitalization lending group could attract financing from private citizens concerned with both financial return and the social impact of the group's activities. Requiring its members to complete a financial education program or provide a shared guarantee could improve repayment rates and hold down future interest costs.

Larsen agrees that the lending group model holds potential for community development because the lending platform allows for a free flow of captial and leaves the lending decisions in the hands of group members. By developing underwriting criteria not currently considered by traditional financial institutions, these alternative lenders may be able to provide valuable insight for conventional lenders.

Balancing risk and reward
The system is not without risks. Because the process leaves financial decisions to the discretion of borrowers and lenders, the success of loan transactions will depend on the participants' ability to anticipate risk. Recent mortgage performance seems to demonstrate that some consumers also lack fundamental understanding of financial products. Borrowers may benefit from guidance or increased disclosure to make sound decisions.

As intriguing as the peer-to-peer lending industry may be, it is in the early stages of its growth. How the industry develops will depend on user virtuosity in making the most of what the medium has to offer. The impact of a slowing economy on P2Ps' performance remains to be seen. Nevertheless this burgeoning trend could give community and economic development initiatives a new tool for private investment and thus reduce dependence on public financing.

This article was written by Ana Cruz-Taura, senior regional community development director at the Atlanta Fed's Miami Branch.