As we watch the stock market take record nosedives and banks close their doors, people are beginning to wonder: Will I be able to get a loan? Where should I invest my money? Some of these people are searching for alternatives to traditional financial centers.

Enter peer-to-peer (“P2P”) lending. On the one hand, you have people with a need — credit card debt, wedding bills, small business capital. On the other, you have people with a little extra cash looking for an investment. P2P lending networks provide the bridge between these two groups. The Internet provides the forum, making such massive online communities possible.

These communities typically take the form of either an auction-based marketplace or a “family and friends” network. In the marketplace model, anonymous lenders bid rates for loans to anonymous borrowers. The lowest rate bidder “wins” the loan. Examples of this social lending model include Prosper, Zopa and Lending Club. The “family and friends” model, such as Virgin Money, links borrowers and lenders who are acquaintances and wish to formalize a personal loan. The host network provides the formalities, but does not match borrowers with lenders.

When these networks function as intended, one or more lenders support loans to borrowers, usually between $1,000 and $25,000. The term is typically three to five years, with a fixed rate determined by the lender. These rates are usually lower than those available at traditional lending centers. Some networks limit potential borrowers by requiring a credit rating of at least 640. Others are less restrictive. The host network provides the credit check and procedural niceties for nominal fees.

But what happens when a borrower defaults?

P2P loans are usually unsecured, and the networks are not insured by the FDIC. Even though some networks are affiliated with banks or credit unions that subject them to governmental regulation, lenders have few solid options when borrowers cannot pay back loans. Most networks provide access to collection agencies that assist in the recovery of outstanding loans, though usually at the expense of a hefty fee of 15-30% of the recovered funds. The defaulting borrower is charged late fees, banned from the lending network, and reported to the credit bureaus.

P2P lenders are strongly cautioned to diversify so that potential defaults will have less impact on the lender’s portfolio. Borrowers are cautioned even more strongly to use lending networks wisely, since an inability to pay back these loans can damage one’s credit just as much as a default on a credit card or other more formal loan.

Additionally, small business owners should exercise caution before turning to P2P networks. Even sites advertising “business loans” are actually providing consumer loans based on the business owner’s personal credit. Large amounts of debt, even if used for business purposes, can hurt an individual’s credit score and reduce the ability to borrow larger sums from more traditional financial institutions in the future.

So do P2P networks work?

The initial results point to “yes.” Even though some borrowers do default, Akash Agarwal, founder and chief executive of Green Note, points out, “The pressure to pay back a loan is pretty visible because you know where the money is coming from — it’s coming out of someone’s pocket, not some bank warehouse.” Borrowers thus feel an increased social responsibility to repay loans. On the other side, lenders feel like they are contributing to someone else’s betterment, while still making a few dollars. Formalizing loans amongst family and friends also helps minimize the potential for divisive argument over repayment. The social welfare aspect, often lost at larger, more formal institutions, is thus an important and powerful motivator in the P2P scheme.

Economically speaking, P2P loans can be effective financial boosts when used wisely. They can help young borrowers or fledgling business develop credit. They can assist others in consolidating debt into more manageable payments and in beginning to rebuild credit. They can help pay for student loans when subsidized federal loans are unavailable or simply finance life events such as marriage or home remodels. They can also help grow wealth for lenders who are looking for a more stable investment. In theory, this manageable debt and wealth creation can develop a stronger economic base, even in tough financial times like these.

But is P2P lending legal?

There are a lot of legal questions surrounding P2P lending: How do lenders protect members’ privacy? How is identity theft prevented? How are taxes determined? But most importantly, how are these relationships to be regulated? Should these transactions be treated like private contracts? Should individual lenders be treated as agents of the P2P network? Should these networks fall under the umbrella of traditional banking regulation? How can current banking laws be adapted to this new system? What law governs when a corporation registered in Utah facilitates in a private loan from an individual in California to an individual in New York? Given the newness of online social lending, these questions are still being answered.

Increasing regulation is already changing the face of social lending, though. Although many P2P lending networks began as direct lending programs, several, such as Zopa and Lending Club, have shifted to selling financial products like CDs. For example, Lending Club recently filed a registration with the SEC. Under the new, more regulated system, Lending Club would sell payment dependent notes to lenders rather than organizing direct loans from lender to borrower. The proceeds of the sale of the notes will then fund the borrowers’ loans. The “personal” side is maintained through the lender’s ability to choose which borrowers receive these funds.

Many are blaming the current financial crisis on a lack of regulation. So why would we want to turn to a less -regulated system? The answer is that increasing regulation decreases the community appeal of P2P lending. More regulatory controls push these networks closer to traditional credit unions and further from “people helping people.” While some control is obviously necessary, I would argue that too much regulation would cause the social lending system to break down. Social lending works because participants feel a connection with the people they are lending to or the people they are borrowing from. This human side encourages investors to invest and borrowers to repay. When regulation forces greater separation between borrower and lender, this incentive declines.

As with all things, only time will tell regarding the fate of P2P lending, but I predict it will continue to grow, especially if the economic instability persists. I also don’t think the rise of grassroots lending is such a bad thing, especially since it re-injects a sense of personal responsibility into the financial world. Though it will not prevent future bailouts or replace the traditional financial system, I think it can become an important supplement. There are, of course, risks for both borrowers and lenders, but the small size of the loans, lower rates, diverse lending portfolios, and accountability involved in social lending help to minimize the overall impact of defaulting borrowers.

Now, I wonder if anyone out there wants to help finance a law student’s education…

–Rachel Perkins

Photo courtesy of Tracy Olson.

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