For some extraordinary reason, many Americans aren't wildly enthusiastic fans of banks and other providers of financial services. You can track their growing disillusionment through Hollywood movies. In "It's a Wonderful Life" (1946), Jimmy Stewart played George Bailey, who was both a banker and a hero. In "The Wolf of Wall Street" (2013), Leonardo DiCaprio played Jordan Belfort, a real-life monster of the financial services sector, whose cocaine-fueled avarice and moral turpitude were, many say, only slightly more exaggerated than those to be commonly found in some big-name banks. By now, you may want to ask: Is there an alternative to the current Wall Street model?
What Would a World Without Banks Look Like?
Last July, The Financial Times posed a similar question: "What would a world without banks look like?" It was prompted to ask that by the rapid emergence of of an alternative: peer-to-peer (P2P) lending and borrowing.
What's that? Well, it's a bit like eBay, except instead of providing a Web-based platform that introduces sellers and buyers, P2P lending sites introduce lenders and borrowers. Although those sites pre-screen borrowers' creditworthiness, provide collection services (if necessary), and have plenty of other expenses, their marketing and operational costs are on average roughly one-third those of traditional banks, according to Deloitte. And that means, generally speaking, that lenders can earn from these innovators significantly higher yields than those offered by banks' so-called high-interest savings accounts, while borrowers may pay lower interest rates than they would with mainstream personal loans.
Many individual lenders like this model, which permits them to diversify their risk by funding a tiny part of many loans, rather than effectively betting on getting repaid by a small number of borrowers. This may explain in part both why the U.S. P2P market is growing exponentially, and why hedge funds, wealth management firms and other institutional investors are weighing in. However, PBS Newshour's website ran an article in January warning that many small investors are underestimating the risks attached to these loans.
P2P for Borrowers
Of course, such considerations need not concern borrowers. Once you have a loan, all you have to worry about is paying it back. There are now a number of P2P lending sites serving the U.S., but the two big ones remain: Lending Club (no relation to LendingTree) and Prosper. Most of these platforms are likely to follow, with minor variations, a similar loan application process:
- You visit your chosen site and register. You have to provide basic information at this point.
- The platform runs a standard check with a credit bureau to make sure you qualify for borrower membership.
- If you're provisionally accepted, you can post your loan requirements and profile, which is likely to include at least your income, the amount you owe other lenders, your employment status and the purpose of the loan. "Debt consolidation" is frequently fine for the last of those.
- Credit information is also shared with prospective lenders at this point, and is likely to help determine the rate you eventually have to pay, as lenders weigh the risk you pose with the rewards you offer. At the time of writing, Prosper, for instance, says its fixed rates vary between 6.73 percent and 35.36 percent APR, though these may change.
- Lenders can view your profile, and may, if they wish, offer to fund all or part of the requested loan.
- The platform is likely to verify your identity and may demand documentation to confirm claims you made about your income, employment and so forth.
- If a loan application is verified and fully funded by individual lenders, the platform deducts its origination fee (Lending Club's, for example, currently ranges between 1.11 percent and 5.00 percent of the amount you borrow), and electronically transfers the balance into your nominated bank account.
Different platforms are likely to have different rules and may perform the stages of this process in a different order. Be wary of a site that tries to charge an upfront origination fee, and make sure you know all the charges for which you may be liable before you sign up.
Personal Loans vs P2P
If you're a lender, you have to trade risk for reward when you use a P2P platform. When you put money into a mainstream savings account, you can -- unless your deposit exceeds FDIC limits -- be virtually certain you're going to get back every penny you invested, plus all the interest you've been promised -- regardless of any stupid lending decision your bank makes. P2P lenders tend to invest small amounts in large numbers of loans, because they know they stand to lose their entire investment in -- and all expected interest from -- any of their loans that default.
If you're a P2P borrower, you have many fewer worries. Providing you choose your platform with care, and make sure you fully understand all the costs, terms and conditions, you may be able to get the money you want at a lower cost.
Caution! Disadvantages of P2P Borrowing
The biggest disadvantage of trying to borrow from a P2P site is probably the fact that it's very difficult to get approved and funded. Both Prosper and LendingClub admit that they fund fewer than ten percent of the applications they receive.
A more dangerous downside is what may happen to your privacy.
University of California Davis Law Review says in its publication The Misregulation of Person-to-Person Lending, "Borrowers also face special risks in a P2P environment...In order to solicit interest from lenders, P2P borrowers share personal information on the platform’s website. This information is available to anyone who ventures online, including thousands of tenacious lenders."
The State of California Senate Banking Committee said in a recent report that while P2P lending is a promising and growing industry, "It is, however, important to acknowledge the youth of the industry and some of its operating risks."
Keep Shopping Around
The benefits of P2P borrowing may be substantially overstated by journalists. The Mis-regulation of Person-to-Person Lending claims, "Platforms also implicitly subsidize glowing reviews by users who blog. Both Lending Club and Prosper pay referral fees to blogs and webpages that recruit customers. As a result, these sites have an incentive to overstate the rewards of P2P lending, and many of them do."
It makes sense, if you're looking for the lowest rate on a personal loan, to apply with reputable P2P sites -- but you should also shop with traditional lenders. It's smart to check with trusted LendingTree personal loan providers (compare personal loan quotes here) in addition to P2P investors.
The golden rule remains: Comparison shop until you drop before committing yourself to any financial product.