Lenders Get Personal

Suzanne Specht’s job is to help make dreams come true. She serves as the assistant director of the Small Business Development Center (SBDC) at Florida Gulf Coast University, helping entrepreneurs realize aspirations of owning their own businesses. But Specht knows this isn’t Disney; dreams cost money, and more often than not, the financier is a bank.

Banks, however, aren’t handing out as many dreams as they used to. “Banks are getting very, very picky,” Specht says. According to the Federal Deposit Insurance Corp., Florida banks funded nearly $8 billion less in loans in March than in March 2007. “So a lot of [SBDC] counselors are seeing a move to social lending,” Specht says.

“It is true that lending standards have changed,” Carol Kaplan of the American Banking Association says. “It’s all a part of regulatory reform … if banks can’t charge some people a higher interest rate to cover their risk, they just stop lending to those people.”

Social lending, or peer-to-peer lending, is helping fill the void by sidestepping financial institutions altogether. In essence, social lending matches individual lenders with individual borrowers. It serves as both an investment opportunity and as a real alternative for borrowers.

“Loans are funded through other Americans,” says Chris Larsen, CEO and co-founder of Prosper.com, a social lending website. “It’s the final stage in democratizing the [loan] process.”

Peer-to-peer lending in its most popular form works through a website, such as Lending Club or Prosper, that accepts borrowers and assigns them a credit designation based on their credit score. Lending Club investors choose borrowers they wish to fund, who then repay the loan based on an interest rate commensurate with their credit score. For example, the average interest rate for someone with an “A” grade, the best, is 8.6 percent, and 18.3 percent for a borrower with a “G” grade, the worst.

Prosper.com investors bid on borrowers in an online auction with the lowest interest rate winning the loan. “It’s like eBay for lending,” Larsen says. The average interest rate for borrowers with a credit score higher than 640 is 14.5 percent, and 23.7 percent for those below.

The demand for peer-to-peer loans has increased as the economic downturn grows longer. Lending Club’s loan demand jumped from $260 million at the beginning of 2009 to slightly less than $1.3 billion in April 2010. “Banks have become tighter and they’re not lending to even the most reliable borrowers,” says Rob Garcia, senior vice president of product strategy for Lending Club.

That doesn’t mean that peer-to-peer lenders are willing to shell out money to just any borrower. Although Lending Club had been petitioned for almost $1.3 billion worth of loans, it has accepted only $115 million of those requests. Lending Club investors receive an average net annualized return of 9.6 percent.

“We’re doing what the banks should’ve been doing,” Garcia says. “Banks take deposits from people and lend to other people. They spend half their time convincing you your money is only worth 1 percent [in a CD] and half their time charging you 5 to 20 percent to take a loan.”

When it began lending, Prosper was less discriminating in its acceptance of borrowers. In 2007, 42 percent of its loans were issued to people with credit scores lower than 640. As a result, by 2009 nearly 20 percent if its issued loans had defaulted, compared with 4.2 percent for Lending Club at that time.   

In July 2009, Prosper heightened its borrower standards. Now, no one with a credit score lower than 640 may receive a loan. Consequently, Prosper’s average investor return is 10.5 percent and its default rate is 5.5 percent since July ’09.

While a borrower’s credit score may be just as important to peer-to-peer lenders as to banks, social lending has a little more room for emotion to creep into the process. On both Prosper and Lending Club, prospective borrowers can tell their personal story in an attempt to entice lenders.

“Borrowers control the process of getting a loan,” says Larsen. “They make their own pitch, they sell their trustworthiness, reveal their small business—things that they believe are important to know besides the numbers.”

But is it wise to mix emotion and business?

“I think it is. People walk away from their mortgages because they don’t owe any loyalty to the business,” Larsen says. “In human beings there is shame in not repaying another person. We see that in the data.”

Kaplan disagrees. “I just can’t imagine a bank examiner asking why a particular loan was made and being told, ‘Well, he seemed like a nice guy.’ You’d get your charter revoked.”

It’s this kind of plea that Specht hopes will attract a loan for a client with a killer business plan, great financial projections but poor credit depth, which means she has a good credit score but hasn’t created a large footprint.

A social lending loan can be used for anything, and its early history shows that a large majority are going toward debt consolidation and credit card refinancing loans, not to businesses.

Still, at least there’s another option. Says Specht: “Now people can look at her story and say, ‘I was there, too, once.’ ”

As far as the social lenders, they’re counting on a public whose mistrust of banks isn’t fleeting. Plus, Garcia says, they don’t possess the overhead of banks, so after the recession, they’ll continue to thrive. And, with current technology, they say, banks are obsolete as lenders.

“We’re bullish about where it’s going to go from here,” Larsen says. “People are angry at the banks. Well, right now we have the technology for individuals to be the bank.”