This post is from Joseph Hogue who is a Chartered Financial Analyst and blogs about peer lending and crowdfunding. He’s helping me out while I am off visiting my kinfolks in Kentucky!
If you haven’t heard much about peer lending yet, odds are that you soon will. Though the industry has been around since before the financial crisis, it has only just become popular over the last couple of years. Now the largest peer lending platform in the world, Lending Club, is issuing shares on the New York Stock Exchange and the media is all over the story.
Despite the media attention, there are still quite a few misconceptions about peer lending and what it might mean for investors and borrowers. In my conversations with investors and borrowers, I’ve heard time and again three pervasive myths that keep people from using this revolutionary new form of finance.
Peer Lending Myth #1: Peer Lending is only for People with Bad Credit
This one couldn’t be further from the truth. In fact, the minimum credit score for borrowers on the two major peer lending platforms is 640 with an average score of 726 across all borrowers. A little over a fifth of borrowers enjoy rates under 10% on their loan, well under the rates on other forms of unsecured personal credit.
Peer lending is emerging as a mainstream way to borrow money and reach a number of financial goals. Debt consolidation still remains the most cited loan type but borrowers are discovering online lending for other needs like home improvement, education loans and medical expenses.
Peer Lending Myth #2: Peer Lending is too Risky to be a Legitimate part of My Investments
This misconception goes back to the earlier days of peer lending. Lending Club first started originating loans in 2007 with a default rate across all loans of 15% and 12% in the first two years. The default rate for loans originated since 2010 is less than half that, averaging just under 5% with the default rate similar on the Prosper lending site.
There are two reasons for the poor performance of earlier loans. First, both peer lending platforms used different credit rating models in their early days. These technical models for measuring risk were not particularly good and a lot of loans probably should not have been made. More importantly, it was just a matter of bad timing for the industry. Even home mortgage loans saw default rates jump during the collapse of the financial system and are still around 7% more than five years after the end of the recession.
Default rates may increase in another recession but they are unlikely to hit 10% even in the worst case scenario. Even at 10%, returns on a diversified portfolio of peer loans would still break even according to data from Prosper. I doubt that a portfolio of stocks would break even if the economy enters a recession.
Peer Lending Myth #3: Peer Lending is a Fad and Will Never Last
I remember when the first cell phones became popular in the early 80s. They were interesting and there was certainly a lot of media attention but many thought they would never become mainstream devices. After all, who would want to carry around a four-pound brick with them everywhere they went.
Peer lending is gaining momentum as a viable source of borrowing and a great opportunity for returns. There is really nothing new about the business model. Investors have been buying loans for ages, but always had to go through several layers of middlemen in the past. These layers of banks and brokerage firms added on their own costs and profit. Peer lending is simply connecting borrowers directly with investors, without the additional cost of bank branches and brokerage offices.
Lending Club will raise nearly $1 billion from its initial public offering of stock and Prosper is originating upwards of $200 million in loans every month. While we’ve dispelled three popular misconceptions here, there are bound to be others. Whether a borrower or investor, you owe it to yourself to look further into the newest form of finance and how it could help you reach your financial goals. For more detail on the two peer lending platforms, Prosper and Lending Club, check out my peer lending sites review for information on which site might be right for you.
Author Bio: Joseph Hogue, CFA
Peerloansonline.com is your first stop into the world of peer lending. Whether a borrower or an investor, you’ll find everything you need to make your experience a success along with tips on personal finance and managing debt.