Typically, an entrepreneur will post a profile explaining his business, background and what he or she needs money for. Investors can peruse the postings and choose which opportunities they'd like to back. When terms are matched, a deal is struck. The sites handle the back-end of the transaction, disbursements, recordkeeping, payments, identity verifications, credit checks and collections. They charge either a percentage of the loan amount or flat fee. While borrowers' identities are shielded for their protection, these sites have won kudos for their transparency.
"It's popular but it's a very difficult model," says Keith Weigelt, a management professor at Wharton. To be successful in the long term, "the site has to keep getting a lot of people involved."
Peer-to-peer lending has a strong social aspect and it is also known as social financing. Why? Investors may choose to back a venture based on the borrower's background, hobbies or other personal attributes. Often, match-making tools add a social-networking component.
Other benefits include loan rates that often are competitive with those from banks and other sources. For investors, the returns often beat out other investments, even if a few of their loans go sour.
The future of peer-to-peer came into question in 2008 when several sites shut down after federal securities regulators began looking into how they should be regulated. But most soon reopened under federal and state oversight, and some industry watchers expect their business to boom as the credit crunch drags on. Celent, a financial-services industry research firm, projects peer-to-peer lending to reach $3 billion this year.
Peer-to-peer financing can take many forms. While there are many players in the field, no one competitor stands out from the rest, according to Weigelt.
"I don't think anyone's really broken out from the pack," he says. Your best bet, he says, is to sample a few and see which one works best for you.
Here's a rundown of some of the better-known services.
- Prosper.com: Works like an online auction where people and institutions list and bid on loans. The site combines lenders' bids with the lowest rates to facilitate the funding of one single loan to the borrower, and issues notes to the winning bidders.
- LendingClub.com: Lenders make investments and the money goes to the borrowers they choose. Many lenders build a portfolio of loans based on their own criteria.
- VirginMoney.com: Helps manage business loans between relatives and friends, including handling legal documents, payment transfers, and year-end reporting.