Fed up with your high interest credit cards? Need a quick loan to make some home improvements or repair a car? Or perhaps you are planning a wedding or a new creative project such as a film or music production. Since it’s getting harder and harder to get a traditional personal or business loan from a bank (especially without collateral), a perfect solution could be online micro lending. Also known as peer-to-peer lending, sites such as Prosper and Lending Club help borrowers find lenders for amounts ranging from $1,000 to $35,000.
How to Start
The way it works is you first fill out a questionnaire to determine your credit risk. This is not meant to disqualify you as a borrower but rather to set your loan’s interest rate. If you’re concerned about your credit score going up just because they are checking your credit, don’t be as it’s just a “soft check” that will have no effect on your score. Interest rates range from 5.99% to 36.0% APR, with the typical rate about 13% APR. An origination fee of 1-5% of the loan amount is deducted directly from your loan proceeds, and monthly payments are made for terms ranging from 24 to 60 months.
What’s nice is once your interest rate is set, it stays the same even if you miss a payment. Late fees are also lower than a bank’s, usually around $15, and there are no prepayment penalties if you decide to pay the loan off early. The money you borrow is transferred directly to your checking account usually within four days after approval.
So why would a perfect stranger want to lend you money? The reality is there is usually more than one person investing in your loan. Lenders are putting up a certain amount of money (a minimum of $2,500 is recommended) and that investment is spread over numerous other loans in $25 increments. The riskier the loan the higher rate of interest a lender receives. Even if some of the loans default, the lender is assumedly earning money on many other loans.
Online lending could be a good way to get a loan if you don’t have much of a credit history or are carrying a lot of student loans that make you “unattractive” to traditional banks. Your interest rate could be a bit higher than if you come in with a high credit score, but if you need money fast, peer-to-peer lending could be a better alternative than the outrageous interest rates charged by payday loans, for example.
Peer-to-peer loans are also a great way to start a new business. Murat Uyaroglu of New York City wanted to expand his coffee bar and cafe, and previously had to wait six months to close on a Small Business Administration loan. He had also been rejected at a traditional bank, so he decided to give Lending Tree a try. After spending about 10 minutes filling out the online application, he was quickly notified that he qualified for a $30,000 loan. Uyaroglu chose a one-year term at 19.9% APR and only had to upload bank statements and his most recent tax return. Five days later the money was in his bank account.
Not all states have approved peer-to-peer lending–some analysts fear another financial bubble–so check the Prosper or Lending Club website to see if your state is eligible. This may be one of the reasons why this type of loan is not as well-known, but the Lending Club, for example, has been in existence only since 20007 and has already reached over $7 billion in loans.
While just about anyone can qualify for a peer-to-peer loan, the average interest rate is not that low at 13% APR. But if you are paying 18% APR or more for a credit card, paying for a wedding, or want to start your own business, peer-to-peer lending is an alternative worth investigating.
Become a Lender for a Good Return
With peer-to-peer lending you can make a good return on an investment by becoming a lender yourself. Every borrower is rated according to his or her credit history and income, and then an interest rate is assigned. Some investors choose more risky loans that pay a higher interest rate while others play it safe and get a lower rate. Or you could choose a mixture just like you would do in any investment portfolio. You can manually invest choosing your own loans or use their automated system after you choose the type of loan risk you want.
With Lending Club you invest in $25 notes or portions, and they recommend you start out with $5,000 to spread your investment over 200 equally sized loans. This greatly reduces your risk as you aren’t putting all your eggs in one basket. You can start out with as little as $2,500 but would have to invest in A-grade loans that pay a lower interest rate. The Lending Club claims that 99.9 percent of investors that own 100 or more notes of relatively equal size have seen positive returns.
These returns generally range from 5-10% APR that take into account a 4-5 percent default rate plus about 1% of the loan amount in fees charged. If that return sounds measly, compare it to what you would earn in a traditional savings account or money market where you’re lucky to get .5% APR. Keep in mind there will be some defaults as borrowers are not putting up any collateral and could file for bankruptcy at any time.
If you really want to get serious about investing in lending clubs, consider automated investing. First you choose a mix of loan “grades” according to the amount of risk you want to take on, and then set the maximum amount for the loans. The tool will then choose loans and invest for you and send a daily report. The cash that comes into your account as borrowers pay back their loans can be automatically reinvested into new loans or transferred to your bank account.
To take it a step further and get tax advantages as well, with both Prosper and Lending Club you can roll over a 401(k) account, make an IRA transfer or open a new IRA. Traditional, Roth, SEP and SIMPLE accounts are all available.
Simon Cunningham of Grand Rapids, Michigan is an active investor in both Prosper and Lending Club, and with an ongoing investment of approximately $20,000, he earns about 13% APR per quarter. He publishes an online newsletter and tutorials for beginners at his website LendingMemo. Diversification is the key to success, as another investor in Texas reported he chose three loans to invest in and they all defaulted.
A new economy combined with technology opens up many opportunities for borrowing and lending. To take full advantage, keep that credit score high!
Suzanne Driscoll writes on finance and money management for MyBankTracker.