Sunday, August 24, 2008

From the Ground Up

(WP) With bank loans scarcer, a handful of Web sites help borrowers tap individuals for cash.

Steve Lubs was looking to get rid of his $8,000 in credit card debt, but his high interest rate had him bogged down. He tried getting a loan through a bank to pay off the balance but couldn't find one with an interest rate lower than 12 percent.

That's when he turned to Prosper, one of several peer-to-peer lending networks that connect people who need a cash infusion with those who have money to lend. About 70 people have pitched in with $100 to $300, totaling the sum he needs to get out of debt, at a rate of 8 percent.

"When it comes to borrowing, it's a bargain," said Lubs, an engineer who lives near Columbia.

Rather than turning to the traditional sources of loans -- banks, mortgage lenders, credit unions -- many cash-strapped consumers are borrowing from friends, family members and even strangers and are getting favorable terms and rates. And people with money to spare see lending it to others as a better investment than socking it away in a low-yield savings account or playing the volatile stock market.

"Worthy borrowers used to have lots of options, but those have dried up," said Chris Larsen, chief executive of Prosper, where about 780,000 users have exchanged $160 million since the lending network launched 2 1/2 years ago.

Getting a loan isn't as easy as it once was, as interest rates have climbed and credit standards have tightened. At the same time, demand for loans is rising. High gas and food prices make it harder to save and pay off existing debt. Home-equity lines of credit are harder to come by, leaving many people short on the costs of home improvement and other expenses. Some people also find it difficult to use traditional lending to finance a car or a graduate degree.

As a result, several peer-to-peer lending networks have sprung up, with names like Zopa, Virgin Money and Lending Club. Some, such as GreenNote and Fynanz, offer loans exclusively for students.

But using such networks can be a gamble for both lenders and borrowers. Loans made through some networks are not insured by the Federal Deposit Insurance Corp. Some networks are affiliated with credit unions or banks, which are regulated by the federal government.

Lenders run the risk losing their investment if people don't pay them back.

The networks supervise the loan agreements by checking credit histories. But if a borrower defaults on a loan, a lender's only recourse is to report the borrower to collection agencies. And not all networks are licensed to make loans in all states.

For borrowers, replacing existing debt with a new loan could lead to deeper financial problems. Personal-finance advisers say borrowers could find themselves in a worse financial hole if they use the networks like just another credit card.

Borrowers must be creditworthy, and both borrowers and lenders must divulge private information such as bank accounts and driver's license numbers to get started, raising privacy concerns among some observers.

Prosper lets people borrow or lend up to $25,000, typically by piecing together 50 to 100 small loans. The process is similar to the way an eBay auction works: Borrowers set the maximum interest rate they're willing to pay, and lenders compete to make the best offer. Users looking to borrow money can share how they plan to spend it, whether it's to buy a house or to pay for a wedding.

They can also invite friends to join. "If you get a friend to bid on you, it increases other people's trust in you," Larsen said. "That's where the social capital comes in."

Prosper oversees the process. It checks credit scores for both borrowers and lenders, verifies bank accounts, and then sets the repayment terms.

At first, about 30 percent of the users had blemished credit records that prevented them from qualifying for more traditional loans. But a wider variety of borrowers have joined the network in the past year, Larsen said.

"People looked at peer-to-peer networks as a place you go when you couldn't go anywhere else," he said. "Now it's become one of the new alternatives that's still open."

Lubs has also used Prosper as an investment by loaning small amounts of money -- typically $200 to $1,000 -- to people looking to borrow funds. He has 37 outstanding loans to network borrowers, totaling about $9,000. He said he's been earning an average annual return of 19 percent on the total amount, which is better than what he gets on his investments in the stock market and real estate.

"This is my primary method of investing," he said. "It's the best opportunity I have to increase my rate of return."

Carson Evan of Alexandria used Virgin Money to lend his younger sister $17,000 to pay off her credit cards. With her interest rates, she would have needed 15 years and $70,000 to pay off that debt. Instead, she can repay her brother's loan over five years at 3 percent.

"I know I could be getting a better return on it someplace else, like the stock market," Evan said. "But this was the right thing to do."

He said making the loan through Virgin Money took the awkwardness out of lending to a family member. Rather than paying him back directly, his sister writes a monthly check to Virgin Money, which then wires the money to Evan.

"It added an air of legitimacy to it," said Evan, a 29-year-old software engineer. "It's better if she's not writing the check directly to me, to pay back her brother, even though she is."

John Vyge, principal with Hillebrand Financial Planning in Dulles, said using a social lending network to correctly document a loan between family members or friends can minimize the chances of the relationship being damaged by a disagreement over the terms or repayment.

But he's still skeptical about the concept of peer-to-peer loans.

"My concern is people are depending on these loans instead of building a sound financial plan, like having an emergency fund," he said. "People can just use these sites as another credit card to fund a vacation or anything else under the sun."

People who use such sites to lend money are mostly protected from losing their money, he said, because the sites check credit backgrounds and keep borrowers on a structured repayment track. Those who fail to pay run the risk of being reported to collection agencies. Diversification is also possible. Lenders can distribute money in a variety of amounts and at different rates.

Konrad Berk of Towson is one lender who is willing to take the risk. He's invested a little less than $10,000 in loans to strangers through Prosper. Each loan is for no more than $50, allowing him to create a diversified portfolio of interest rates.

After he secures an interest rate of, say, 11 percent on a loan, Prosper takes a cut, and a default agency does as well. After accounting for those fees, his return wouldn't exceed 9 percent, he said.

In the 10 months he has loaned money through Prosper, a few borrowers have missed payments -- several in a row, in some cases.

"You don't know how a given default situation will work out in the future," he said. "A borrower could resume payments or stop paying altogether." He said he has accepted the fact that he may not get paid back for a few of the loans.

Still, Berk said he likes the "social benefit" of peer-to-peer lending networks. "I feel like I'm contributing," he said.

Virgin Money focuses on facilitating loans between people who know each other. Chief executive Asheesh Advani started the company in 2001 as CircleLending before it was acquired in 2007 by Richard Branson's Virgin empire. The company has overseen $350 million in loans.

Virgin Money borrowers are considered to be in default if they are more than 60 days late on a payment, Advani said, and the default rate is about 3 percent. If a borrower misses a payment, lenders can choose to add an extra payment to the end of the loan, spread it over the life of the loan or double up on the next payment. They can also choose to forgive the payment.

"In my view, the flexibility is the secret sauce to peer-to-peer lending," Advani said. "Especially in today's jobless, growthless economy, people tend to have shorter-term jobs or are unemployed, but they are perfectly good credit risks."

Some students have turned to similar social networking sites to fund their educations. Carmina Alvarado, a graduate student at Santa Clara University in California, raised the $3,000 she needed for summer school through GreenNote, a two-month-old company that helps students secure private loans by tapping into their social circles.

A financial-aid counselor recommended the service to her when she realized she'd need to find a private loan to pay for summer classes. "At first I didn't know if this was for me because I didn't feel like I had a strong network of people I could e-mail," said Alvarado, 23.

She then started reaching out to former professors, friends and family members. Her sister contributed $100. So did her boyfriend's mother. A woman she used to do volunteer work for loaned $150. A cousin contributed $1,000. The remaining balance -- $1,650 -- came from total strangers.

Unlike typical private education loans, which carry interest rates of 12 to 20 percent, GreenNote loans carry terms similar to federally subsidized student loans. Many loans have a rate of about 6 percent, and some are lower. Borrowers have a six-month grace period after graduating before they have to start making payments.

Alvarado's loan has an 8 percent rate, and she has 10 years after graduating to pay it back. She said she thinks people are less likely to default on a loan from individuals, rather than institutions, even if they don't know their lenders.

"It's more personal -- people who are lending me the money really believe in me, and that motivates me a lot," she said. "They're investing in me, and I'll do the best I can because I don't want that to go to waste."

Akash Agarwal, GreenNote's founder and chief executive, said the system helps students build credit. It can hurt them, as well: If they default, GreenNote will report them to a collection agency.

"You're being underwritten by the social connection," Agarwal said. "The pressure to pay back a loan is pretty visible because you know where the money is coming from -- it's coming out of someone's pocket, not some bank warehouse."

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