The Bank of Mom and Pop
Person-to-person lending is finally ready to take on banks and credit card companies.
Things were looking so good for Prosper.com five years ago. To most people, the economy appeared to be functional, dot-com nightmare stories had faded from memory, and the time seemed ripe for Web 2.0 to take over the world of personal loans. Prosper and several other "person-to-person lending" sites operated like an eBay for credit: Prospective borrowers put up requests for loans, disclosed their credit rating and the reason they needed the money, and tried to make a case for lenders to take a chance on their dream—at attractive premiums.
Though the idea of perfect strangers trading money seemed surreal, several personal-finance experts said they hoped that companies like Prosper could free borrowers from onerous terms set by credit card companies and, worse, payday loan stores. "Looking at it from 10,000 feet, this is a great idea," Elizabeth Warren, the Harvard Law School professor who is now setting up President Obama's Consumer Financial Protection Bureau, told me when I first wrote about Prosper in 2006. "It could have the wonderful effect of making markets work the way they should, driving down the amounts charged for loans to the true marginal cost."
But that didn't happen. Instead, in 2008, the Securities and Exchange Commission shut Prosper down. Regulators charged that the site was offering investment securities without having formally registered with the SEC. Prosper and its competitors, including Lending Club, were forced to get permission from the government for their operations. Prosper was closed for nine months, and by the time it went back up, the financial crisis had destroyed the public's appetite for financial innovation. Worse, there were signs that Prosper's model was fundamentally flawed. As Ray Fisman wrote in Slate in 2009, lenders on Prosper seemed to be swayed by factors that didn't live up to the claim of democratizing finance—pretty women got cheaper loans than homely ones, and lenders were more likely to lend to white people than black people.
But now things are finally looking prosperous again for peer-to-peer lending sites. Over the past few months, the company has remade its operations in order to reduce lenders' opportunity to unfairly discriminate against certain borrowers. Prosper has also seen the public becoming more interested in lending and borrowing through the site; lending activity is rising, and so far, borrowers are paying back their loans at a rate that keeps lenders coming back. If you put your money in a savings account today you'll get back a pathetic 1 percent in interest. Putting your money in Prosper is far riskier than keeping it in a savings account, but it's also far more lucrative. Over the last two years, the company has delivered an incredible annual return of 10.4 percent to lenders. Its competitor Lending Club has delivered 9.65 percent. "We're starting to build a 'third-way' of banking that looks like a better deal for both sides," Chris Larsen, Prosper's CEO, told me during an interview this week. "We think we can now go straight up against the mainstream banking system."
Peer-to-peer lending rests on the idea that traditional banking is gummed up by unfair bureaucracy. For one thing, advocates of these sites say, credit scores don't accurately reflect a person's ability to pay—people with low credit scores are charged too much for loans even though they may be likely to pay. (This problem has become worse after the financial crisis, when sudden job losses forced even people with high credit scores to default on their loans). There's also a lack of competition. The only companies willing to lend to people with less-than-stellar scores are credit card firms—whose terms are punishingly variable—and payday loan centers, which charge 400 percent or more in interest on an annualized basis.
By putting lenders directly in touch with borrowers—rather than through the banking system—person-to-person lending sites claim that they can cut down on overhead costs, thereby making it cheaper to lend to people with poor credit. They also claim something else: That the peer-to-peer process can evaluate a person's creditworthiness better than a one-size-fits-all credit score, revealing that some people with bad credit deserve access to loans. This seems to be playing out—most of Prosper's and Lending Club's borrowers use lower-rate, fixed-rate loans from the sites to pay off high-rate credit they've accumulated with credit cards.
Farhad Manjoo is Slate's technology columnist and the author of True Enough: Learning To Live in a Post-Fact Society. You can email him at firstname.lastname@example.org and follow him on Twitter.
Illustration by Robert Neubecker.