In just the past few years, Peer-to-Peer (P2P) Lending has exploded from a potentially disruptive lending niche to a major segment of consumer borrowing responsible for a whopping $5B of loans in 2014, driven in large part by investor demand for fixed income alternatives that provide better yields in today’s low-interest-rate environment.
Yet the reality is that P2P lending isn’t just about investment opportunities – for many, it’s a key source of borrowing potential, particularly to consolidate and refinance existing credit card and other debts at lower interest rates.
In this “Financial Advisor’s Guide To Peer-To-Peer Borrowing”, we discuss the mechanics of how borrowing via Peer-to-Peer Lending actually works, the rules and requirements, the costs and the caveats, and the situations in which financial advisors should consider exploring a P2P loan as a financial planning strategy for clients!
What Is Peer-To-Peer Lending?
Peer-To-Peer (P2P) lending is the practice of individuals borrowing money from unrelated ‘peers’ who lend to them – as contrasted to the ‘traditional’ practice of borrowers seeking loans from banks and other financial institutions (e.g., credit card companies) who are in the business of lending money.
The peer-to-peer loans marketplace began in the UK in 2005 with a company called Zopa (still the UK’s largest P2P platform), and expanded to the US in 2006 with the launch of Prosper and Lending Club (which remain the top P2P lending platforms in the US). After quick growth, the SEC intervened in 2008 and began to require peer-to-peer companies to register their loans as securities for the investors who funded them (and third parties who wanted to purchase them); after a brief shutdown to adapt to the new rules, the platforms complied and the peer-to-peer lending market has exploded in growth since then.
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In fact, last year P2P loans funded on just Lending Club and Prosper alone amounted to more than $5B of total loan volume, up from just over $2B the prior year and barely $150M just 5 years ago! Though for context, Americans have a total of almost $900B in revolving credit card debt, nearly $1T in automobile loans, and over $1.2T in student loans, suggesting there is still ample room for the P2P lending marketplace to grow further!
<<<INSERT CHART OF TOTAL LOAN VOLUMES – Pull data from https://www.nsrplatform.com/#!/ and illustrate stacked area chart of Total Loan Volume of Lending Club and Prosper from the start through the end of 2014.>>>
How P2P Lending Works – Limits, Rules, And Other Requirements
The basic structure of a P2P loan is relatively simple – it is an unsecured personal loan of the borrower, funded by a peer lender (i.e., an “investor”) who chooses to make the loan in order to receive principal and interest payments.
Loans limits vary from $1,000 to $35,000 on the major platforms, and as a personal loan the money can be used for any purpose, though overwhelmingly the most common reason for borrowing is to pay off credit card debt or refinance other loans. More recently, Lending Club has introduced higher loan limit options for small businesses (up to $300,000), and even an option for those who need to borrow to finance a medical procedure.
Available loan terms are 3 years or 5 years, with ‘normal’ monthly amortizing loan payments to fully repay principal and interest over the loan term. Loans are structured to have no prepayment penalties.
Once a requested loan is listed on the platform, it will either get funded by lenders/investors or removed after 14 days; once funded, the platforms will typically require additional documentation to verify the details (and possibly underlying income and credit verification) and approve the loan, and then release the funds in 2-8 business days.
Underwriting For A Peer-To-Peer Loan
Applying for a peer-to-peer loan still involves the P2P platforms pulling a credit report, not only to assess the credit score (a minimum of 660 for Lending Club or 640 for Prosper is required) but also to look at other data from existing debt balances to checking for prior delinquent payments. That data in turn is analyzed by the P2P platforms’ own proprietary credit scoring algorithms to assess a risk grade on the loan. Lending Club uses rankings from A to G and subrankings from 1 to 5 (so the best risk grade is A1 and the worst is G5), while Prosper rates loans in sequence of AA, A, B, C, D, E, and HR.
Borrowers with a more problematic credit history (e.g., a history of delinquencies) or questionable information in the loan application (e.g., stated income is high relative to the stated job) may further be required to verify their income source (i.e., job/employment status) or outright verify their income itself. Notably, though, income verification is not applicable to all loan situations, in part because the platforms’ own multi-year history of data has found that the loans not income-verified are not defaulting or causing charge-offs at a higher rate.
Costs To Qualify For A Peer-To-Peer Loan
When the P2P loan is funded, it is also assessed an origination fee (how the P2P platforms make their money), which varies from 1% to 5% of the borrowed amount (and is capitalized into the loan, thus resulting in an Annual Percentage Rate [APR] that is higher than just the stated interest rate of the loan). The lower origination fees apply to the highest quality (A-rated) loans, while the lower quality loans will typically pay the full 5% origination fee.
Beyond the origination fees, there are no further charges to borrowers to obtain a loan, although failing to make timely monthly loan payments can result in failed/late payment fees (which pass through to lenders to help offset losses in the event the loan ultimately defaults). If the loan ultimately does default and the P2P platform must engage in a collections process, there are no further charges to the borrower (beyond the late fees already assessed), but a portion of the collections is retained by the P2P platform to cover its costs to collect (and the remainder is passed through to the lender).
Notably, given the relatively small loan amounts typically involved, these origination fees can still be competitive to the fees to establish a loan from a traditional bank, especially when considering the lower rates of interest for borrowers on P2P lending platforms.
Interest Rates For P2P Borrowers
Not surprisingly, the interest rate set on a P2P loan will be based primarily on the credit rating and underwriting details of the borrower, as measured by the P2P platform’s risk models. Notably, the term of the loan – in particular, whether it is the longer 5-year time frame instead of just 3 years – is also a material factor, with 5-year loans being assessed less favorable risk scores and therefore higher interest rates (as with 5 years, there is more time for the borrower to have a change in circumstances that could trigger a default).
<<<INSERT CHART ON “Loan Grades: Risk And Reward” FROM https://www.lendingclub.com/public/steady-returns.action>>>
In practice, today’s interest rates will vary from a low of 5.3% for the highest quality loans, to a high of almost 30% for the lowest quality loans. As noted earlier, the inclusion of the origination fee as well means the total cost over the lifetime of the loan (as measured by the APR) is a bit higher. Still, for those eligible for the highest-quality A-rated loans, stated interest rates range from 5.3% to 8%, which amounts to an APR of 6% to 10% after accounting for the origination fee.
<<<INSERT CHART ON VARIOUS LOAN GRADES AND RATES FROM LENDING CLUB PAGE https://www.lendingclub.com/public/borrower-rates-and-fees.action >>>
When Are P2P Loans Appropriate?
Relative to the kinds of loans that most financial advisors discuss with clients – such as mortgages where a 30-year fixed rate is still hovering around 4% (and just over 3% for a 15-year loan) – the kinds of 6%+ APRs associated with even the highest-quality P2P borrowers, not to mention the double-digit interest rates that apply further down the ratings scale, will likely seem high.
However, it’s crucial to remember that as unsecured personal loans, these rates are not unusual. Their most common point of comparison would be personal credit card debt, where the national average interest rate is around 15% (and even high-quality borrowers with “low” interest rates have an average APR over 11%). And of course, those are just averages – many borrowers have materially worse credit card interest rates that, like P2P loans, cross above the 20%+ rate threshold.
Thus, in practice P2P loans will likely be most appealing as a way to consolidate and refinance existing personal debt at a lower rate; for instance, if a high-quality borrower is eligible for a 6%-8% A-rated P2P loan, that’s far more appealing than a 14% rate for a credit card balance transfer! It may even be more appealing than some high-interest private student loans (though be cautious about refinancing Federal student loans eligible for income-based repayment and debt forgiveness programs!).
In other words, borrowers will generally only pursue P2P loans when their available alternatives are even less favorable, but for many borrowers that really is the case. In practice, as noted earlier, the data shows that almost 3/4ths of all P2P loans are used to consolidate or refinance other (generally-higher-interest-rate) debt, and Lending Club has found that the average borrower reduces their current loan interest rates by an average of 7 percentage points.
Of course, if the borrower does have a means to secure a loan with some kind of collateral – from the automobile loan that collateralizes a car loan, to the real estate that collateralizes a mortgage, to a portfolio for a securities-based loan – the secured loan will almost certainly have a more appealing rate. Yet the reality that, especially amongst younger borrowers, there isn’t always collateral available to post for a loan – thus why there’s over $900B of outstanding credit card debt!
Thus, again, P2P loans may remain an appealing option for those who don’t have access to an alternative like asset-based borrowing against the securities in a portfolio, or a residence against which they can draw on a home equity line of credit or a cash-out refinance (or for a senior borrower, a reverse mortgage). And notably, a P2P loan may also be appealing for those who do own houses but don’t have any equity to borrow against (so a HELOC isn’t an option anyway)!
Borrowing To Invest In Yourself And Your Small Business
Arguably, perhaps one of the most appealing reasons to explore a P2P loan, especially for younger individuals, is not just to refinance existing liabilities, but to invest into your biggest asset: yourself, and your earning potential (i.e., your human capital).
Sadly, existing data on P2P loans suggests that a mere 0.05% of loans are for the purpose of learning and training – perhaps because any required borrowing is occurring in the thriving student loan marketplace instead? – although a somewhat larger 1.4% of loans are used for financing a small business (an area likely to grow as both Prosper and Lending Club have been expanding their lending opportunities around business owners).
Nonetheless, the reality is that for those who are young and still have years of career earnings compounding ahead, an investment into a new business or career has a tremendous “return on [borrowing] investment” potential. Certainly, careful consideration should be given to whether the prospective borrower is really ready to push forward on his/her career (or has a proper business plan formulated to really launch a business). And in at least some cases, student loan options may simply have more appealing financial terms.
Still, the potential for big raises in the early years of a career through reinvesting into personal/career development is significant, which means borrowing to invest in oneself – whether via a student loan or a P2P loan – is worth considering.
Caveats And Concerns Of Being A Peer-To-Peer Borrower
Notwithstanding the prospective benefits of P2P borrowing in the appropriate situation, there are several caveats and concerns to consider as well.
The first is simply to recognize that not everyone will qualify. As noted earlier, a minimum credit score of 640 is required to be eligible for a Prosper Loan (and 660 for Lending Club). And ideally, the borrower should have an even better credit score, and a reasonable debt-to-income ratio, or the prospective P2P borrowing rate won’t be 6%, 8%, or 10%, but more like 15%, 20%, or 25%!
In addition, the maximum loan amount (outside of Lending Club’s business loan options) is $35,000, which may or may not be enough to effectively refinance and consolidate a relevant ‘chunk’ of other debts (e.g., it’s enough to refinance most Americans, but perhaps not some high-income clients who have racked up significant 6-figure credit card debt).
It’s also notable that the maximum loan term over which a P2P loan can be amortized is 5 years (and anything more than 3 years will entail a higher interest rate). For a borrower who is refinancing a loan that previously had a longer term at a higher rate, the P2P loan may bring the rate down, but the required monthly payments may be so high (when amortized over the shorter time period) that they simply won’t be manageable from a cash flow perspective.
Example. A $2,000 credit card balance at an 18% rate with a minimum payment of the greater of 2% or $10 would take over 30 years to pay off, but would have a current monthly payment of just $40/month. But refinancing into a P2P loan at 8% for 5 years would quadruple the monthly payment to $161/month. And a cash-strapped borrower might not have the extra $120/month to make those payments.
And of course, in the (most common) debt consolidation scenario, it’s also necessary to take a careful look at the current debts and their interest rates in the first place, and verify that refinancing them really will reduce at least the interest rate (even if not the payments). And the analysis should account for not only the difference in interest rates and the repayment period, but also the impact of the up-to-5% origination fee for taking out the P2P loan, to ensure the total cost over time is reduced by refinancing.
Nonetheless, the bottom line is that for borrowers who don’t have other options – in particular, for those who can’t engage in asset-backed loans because they don’t own a home to tap for a cash-out refinance or home equity line of credit, nor a portfolio for a securities-based loan – the potential for P2P lending over ‘traditional’ bank and credit card personal loan channels is one to consider in the future!
And as we’ll discuss on this blog in the future, P2P lending makes for an interesting investment proposition for an investor looking to allocate dollars to a fixed income alternative as well!
So what do you think? Have you ever had a client borrow through a P2P platform? Do you have any clients who should be considering this strategy now, with debt to consolidate/refinance and a lack of borrowing alternatives?