Bad credit? Borrowing money from other people online could be the solution.

Innovation, the Internet, gadgets, and more.
April 19 2011 5:14 PM

The Bank of Mom and Pop

Person-to-person lending is finally ready to take on banks and credit card companies.

(Continued from Page 1)

In Prosper's early days, the company relied on an auction model to determine the credit rate between borrowers and lenders. Borrowers told sad stories of financial woe, explained why they were better credit risks than their scores indicated, and put up honest-looking pictures of themselves. Lenders who were swayed by these pitches chose the rate at which to make loans to these people—the more you liked the borrower, the less you'd charge for the loan. (Lenders diversified their money across many different people; in other words, if you had $1,000 to loan, you'd spread it among 10 or 20 borrowers, so any single default wouldn't wipe you out.)

But Larsen now says that letting lenders determine loan rates didn't work very well. "Credit analysis is a complicated business, and we found that people couldn't accurately determine risk," Larsen says. In addition to the problem of discrimination (giving pretty people cheaper loans), lenders were often swayed by emotional cues into charging too little for risky loans—and when the borrowers defaulted, lenders would blame Prosper for losing their money, and they'd leave the site.

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Last year Prosper removed the lenders' ability to choose how much to charge for loans. Now the site uses its own methods to determine a borrower's credit risk, and then sets a price for loans based on that determination. When you sign up as a borrower, you tell Prosper your financial history, and then it gives you a "Prosper Rating" between AA and HR; this corresponds to an interest rate currently ranging between 5.93 percent and 35.64 percent. Lenders on the site now choose which kinds of borrowers they'd like to invest in, but not how much to charge those borrowers for loans; the riskier the loans you're willing to make, the more you're likely to get back in interest. Prosper has also removed pictures of borrowers from its listings. These two changes have streamlined the way the site operates, and made it much less likely that lenders will lose their money by charging too little for risky loans. (Lending Club, which never used an auction model, operates in a similar way.)

Now that Prosper sets the rates for its loans, it might sound similar to how regular banks operate. But it differs in two important ways. When you deposit your money in a bank, the bank doesn't give you, as a lender, any say in how you want that money invested. You can't tell the bank to give you a higher interest rate because you're willing to stomach the risk of loaning to people with low credit. As a result, banks today refuse to offer unsecured loans to everyone other than folks with the highest credit scores. Larsen says that another way Prosper differs from traditional banking is that it has developed risk models that are much more fine-tuned than credit scores. For instance, Prosper found that people who've already borrowed and paid back one loan from Prosper are much likelier to pay back a second or third loan—and, as a result, they should get cheaper loans.

In fact, the fixed-term loans that borrowers get from Prosper are just the sorts of instruments that many consumer advocates recommend for eliminating credit card debt. Larsen says that the only limit to the site's becoming more useful, now, is a lack of awareness—a lot more people could do well to borrow from the site instead of relying on credit cards, and a lot of lenders could make more money here than they can in a bank.

And Prosper isn't the only tech company looking to improve the opaque, closed-off world of finance. It's part of a range of new ventures—including Mint, Square, Kickstarter, and others—that seek to bring a startup ethos to the business of keeping, lending, and borrowing money. There's now even a twice-a-year conference, called Finovate, devoted to these businesses; at the conference, a parade of startups line up to show off their plans to revolutionize finance, and many of them find instant investor backing for their ideas. It might not quite be the dream of a truly democratic determination of risk and credit, but it's one of the brightest hopes in a credit market still shell-shocked from the recession.

Farhad Manjoo is a technology columnist for the New York Times and the author of True Enough.

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