Back in the old days (2004), banks and credit-lenders were the most common government-approved and -regulated ways of accessing debt financing for a small business. (The other ways involved friends and family and shady characters who knew how to break legs.) Ten years later, there are several new debt-lending models evolving that are internet-enabled and catching the interest of traditional lending institutions. Similar to the newly-approved form of equity funding we’ve explored called crowdfunding, the new models match up individuals who want to borrow with those who have funds to lend (at higher interest rates than traditional sources).
The general term for this form of borrowing is “peer-to-peer (P2P) debt,” from the computer networking term for the sharing processing capacity among computers hooked into the same network. There are many models emerging and there are a lot of questions you should ask before seeking a peer-t0-peer loan. And remember: As with any decision regarding finance or money, always consult your personal financial and legal advisors before making any decisions. Peer-to-peer lendings should not be entered into without plenty of research and consideration.
Here are some of the basic questions:
What is peer-to-peer lending?
In a simple definition, it means the practice of lending money to unrelated individuals, or “peers,” without going through a traditional financial intermediary, such as a bank or other financial institution. As a form of credit-based crowdfunding, peer-to-peer lending history finds its roots in the microfinance movement of the late 18th century. Believing that the lower classes in Ireland would benefit greatly from microlending, the author Jonathan Swift helped set up the Irish Loan Fund, which dispersed small loans to individuals who lacked credit experience and collateral, but could still be deemed “creditworthy.” The program was so successful that by the 1800s there were more than 300 microfinancing organizations throughout Ireland.
Microfinance continued to evolve through the nineteenth and twentieth centuries, eventually taking to the Internet with Zopa—the first peer-to-peer lending site of its kind—in 2005. P2P lending giants Prosper and Lending Club followed in 2006 and 2007 respectively.
How does P2P lending differ from crowdfunding?
While P2P is essentially crowdfunding—financing from a pool of accredited investors—it’s different in one important way. According to the credit-based crowdfunding site Funding Circle, crowdfunding is generally reserved for startups or early stage businesses—companies looking for startup capital. Peer-to-peer lending, on the other hand, is more for established businesses, those with both a history of credit and revenue.
How successful has P2P lending been?
Since being founded, Lending Club has issued more than $5 billion in loans to thousands of borrowers (primarily to consumers, not businesses), while Prosper has loaned almost $1.5 billion. In 2014 alone, Lending Club provided $867 million to borrowers and Prosper $680 million. (via: Nickel Steamroller and LendStats)
What types of loans are available?
Depending on your credit score, and which source you choose, you can take out both 3- and 5-year personal loans anywhere between $2,000-100,000, with interest rates between 6.73-35.36% for first time borrowers. While Prosper only allows maximum loans of $35,000 for business owners, Lending Club recently extended that figure to $100,000 and will increase it to $300,000 in the future. (See Prosper and Lending Club for specifics.)
How do P2P lending companies set interest rates?
Essentially the same way banks and other credit lenders set them: By looking at your FICO score, income and credit history.
What are the requirements to qualify?
On top of being a U.S. citizen over the age of 18; having a bank account; and not residing in Iowa, Idaho, Maine, North Dakota and Nebraska; as of March 31, 2014, the average borrower on Lending Club had:
- A 700 FICO score
- 16.6% debt-to-income ratio (excluding mortgage)
- 15.5 years of credit history
- $72,298 personal income
Their website does not list a minimum required FICO score, but Prosper requires at least a FICO score of 640. They also require you to be a U.S. citizen over the age of 18; have a bank account; and exclude borrowing in Maine, Iowa and North Dakota.
An interesting statistic: While Prosper requires a FICO score of 640, in 2014, an overwhelming majority (99.98%) went to individuals with no credit score whatsoever. Why? Because, as stated before, P2P lending sites often rely on more data than purely your credit score. They can judge whether or not you’re qualified in a number of ways—unlike a bank—which means good things for small business owners with bad credit.
The good and bad of P2P lending
- You can receive loans much faster than you might with a bank—think days instead of months.
- Those who aren’t approved by banks due to low credit score, or other reasons, are more likely to be approved on P2P sites.
- There are no penalties for paying off the loan early.
- If you’re denied by a bank, you can still get a great interest rate—as opposed to types of cash-advance loans that may exceed 60%.
- Loans are coming from real people.
- Most will be hit with a 5% origination fee (depends on interest rate), meaning if you’ve applied for a loan of $10,000, you’ll only receive $9,500. The origination fee can go as high as 6%.
- P2P lending is not available to all U.S. citizens. Eligibility depends on where you live.
Notable P2P lending sites
- Lending Club.
- Funding Circle. While they don’t describe themselves as a P2P lender, they are a credit-based crowdfunding site designed specifically for small business owners. The difference? They require accredited investors, while P2P sites do not.
- Kiva. A non-profit organization dedicated to lending to help alleviate poverty.
- Zopa. As noted, the first P2P lending site of its kind, but only open to UK residents.
P2P lending resources
- Lend Academy Borrower Resources
- Lending Memo
- A Quick Guide on the difference between Prosper and Lending Club
(Feature Illustration: SmallBusiness.com, ThinkStock.com)