Personal loans, with a twist

As banks continue to tighten the grip on borrowers, canceling home equity loans and cutting borrowing limits on credit cards, Americans are increasingly turning to a timeless source of credit: one another. Person-to-person lending, facilitated by Web-based companies, is quickly coming of age.

“The credit crisis has put a huge crimp in the ability of the average consumer and the average small business to access credit from traditional sources,” said Ed Kountz, a senior analyst at Forrester Research in Atlanta. “In a time of tightening credit, person-to-person lending has turned into an attractive alternative.”

Borrowing from relatives is as old as the hills, but today’s person-to-person lending market makes that loan more formal and accessible.

The market is dominated by three major players -- Virgin Money, Prosper and Lending Club -- although there are more than a dozen others.

These companies facilitate loans between friends and family by providing loan documents and automatic debits from the borrower’s account. They also serve as matchmakers between strangers wanting to borrow and willing to lend.

The way it works varies from site to site, said Curtis Arnold, founder of CardRatings.com and coauthor of “The Complete Idiot’s Guide to Person-to-Person Lending.” That’s largely because the market for this type of transaction -- also called peer-to-peer lending -- has gotten big enough for the companies to specialize.

Virgin Money concentrates on formalizing loans between people who already know each other. If you want to hit up your parents for a mortgage loan, for example, you can get them on a conference call with a Virgin Money representative and talk through both the interest rates and terms.

If you strike a deal, Virgin Money will then write up the paperwork and collect the payments. The cost for the service varies between $99 and more than $2,000, based on the complexity of the loan and how much you have the company do, said Tim Burke, social lending sales manager at Virgin. If you choose to have it process payments, Virgin Money also collects a processing fee each time a payment is made.

Virgin Money doesn’t dictate the terms -- although it will provide warnings if the loan’s interest rate is so low that it’s likely to trigger tax problems or so high that you’re likely to run afoul of state usury laws. (If you charge considerably less interest than market rate, the IRS considers the lost interest to be a gift to the loan recipient.) The rate and repayment schedule are set by agreement between the borrower and lender. No credit reports are necessary.

If you don’t have well-heeled relatives or simply don’t want to ask a relative for a loan, you’d be better off going to Lending Club or Prosper, Arnold said. These sites aim to bring strangers together to finance small businesses, refinance credit card loans and provide loans to students.

Because the borrowers and lenders don’t know one another, there are safeguards built in on both sides.

To protect borrowers, lenders are not given access to the borrowers’ personally identifiable information. That reduces the chance that an anxious lender will directly contact a delinquent borrower for payment. (Borrowers who go delinquent do need to worry about collection agents, though.) Once lenders agree to fund a certain loan, they’re not allowed to back out, so borrowers also don’t have to be concerned about having promised credit ripped away.

To protect lenders, the sites pull credit reports on each potential borrower and turn away borrowers whose credit scores don’t meet minimum standards. Both Lending Club and Prosper have grading systems to handicap the likelihood that a borrower will default. Lenders use these risk profiles to determine whether to fund a loan and how much interest should be charged. You would, for example, expect a higher return on a C-rated loan than on one that has an A.

Prosper, which revamped its site after a recent registration with federal Securities regulators, actually demands that lenders get returns that are commensurate with the risks they’re taking, a company spokeswoman said. To determine interest rates, the company uses the going rate for a low-risk investment such as a certificate of deposit and adds points based on the likelihood that the borrower will default. So if the going CD rate is 2.5% and the loan you’ve bid on is calculated to have a 6% potential default rate, the site will not allow the interest rate on the loan to fall below 8.5%.

To figure out the risk of default, Prosper uses a formula based on the borrower’s history and its own experiences.

“We have a system that we think ensures that both sides get a fair deal,” said Chris Larsen, Prosper’s chief executive and co-founder.

For those who have money to lend, peer-to-peer borrowing represents an investment -- albeit a risky one.

“I could invest my money and get 2% in a money market account or I can get 7% to 9% lending it out,” said Arnold, who has invested his own money in person-to-person lending. “And if you’re able to lower somebody’s credit card rate to 9%, that’s great for them too,” he said.

But making loans is risky business, said Bobbie Britting, research director of consumer lending at TowerGroup.

“Any borrower could have their circumstances change and find that even if they wanted to make their payments, they’re not able to,” she said. “Most of these are unsecured loans [not backed by collateral such as a house or car] and those are the riskiest.”

Since its inception in 2006, Prosper has registered a 19% default rate, Larsen acknowledged. The company has significantly tightened its lending criteria in the last few months and no longer accepts subprime loans, so Larsen expects that rate to improve. However, even Virgin Money reports that about 5% of its borrowers don’t pay on their loans either.

Britting says that defaults shouldn’t dissuade lenders from jumping in. But she urges investors to diversify -- never lending more than they can lose to one borrower and spreading their loans around.

“You should ask yourself if you can afford to lose 20% of your investment,” she said. “Lending is inherently risky. You have to be prepared for that.”

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