Peer-to-Peer Lending: Problems and Promise

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Both Lending Club and Pertuity require prospective borrowers to have a minimum FICO score of 660; the average score is 714 at Lending Club and 740 at Pertuity. Lending Club pulls the credit report and quickly posts qualifying loans with assigned interest rates to the Web site for lenders to review and decide whether they want to fund them. Meanwhile, the platform's underwriters verify employment and income for a random sampling of about one-third of the loans posted. Fixed interest rates are assigned based on credit histories, with the lowest rate around 7.8% and an average rate of 13%. In March, Lending Club added a self-directed IRA account option to enable investors to defer paying taxes on their returns.

Possibly a $1 Billion Industry by 2011

Since it started as a Facebook application in May 2007, Lending Club has made more than $33 million in loans as of Apr. 3, and has turned down loan requests equaling nearly nine times that amount. Of the 3,904 loans issued, 4.2% have defaulted and another 3% are between 30 and 120 days late, while almost 6.2% have been prepaid. Prosper has issued 28,939 loans worth a total of $178 million, 20% of which have defaulted, with 20% prepaid and 4% at least 30 days late.

Michael Kalscheur, a financial consultant at Castle Wealth Advisors in Indianapolis, likes that Lending Club has declined most of the loans for which borrowers have applied. That tells him "that Lending Club protects the investors from bad apples who are likely to increase defaults and lower everyone's profits," he wrote in an e-mail.

Lending Club's loan volume has doubled since the fourth quarter of 2008 and Laplanche expects the platform to process $150 million worth of loans this year and $350 million in 2010. Depending on how many new players enter the market, it could grow to become a $1 billion market within two years, he says.

Given the $1 trillion size of the consumer lending business and the fact that the asset-backed securities marketplace that allowed it to expand is moribund and won't come back soon, Kim Muhota, founder and chief executive at Pertuity, also sees potential for peer-to-peer lending to grow to be a billion-dollar industry within the next two years.

Pertuity's Borrower Rewards Program

Peer-to-peer lending has been criticized for not making loans widely enough available to fill the gap left by the collapse of the asset-backed securities lending model, but Pertuity Direct, the newest entrant, which launched in late January, isn't interested in being the lender of last resort to high-risk borrowers. "It's set up to reward good borrowing behavior," says Muhota. Hence, the Pertuity Bucks program, which allows investors to review individual borrower profiles and track their repayment behavior before deciding to award a certain portion of their annual $500 reward allotment to those who consistently make payments on time.

Borrowers then use those reward dollars to pay down the principal on their loans. When multiple investors are rewarding the best performers, it can add up to significant principal reduction, says Lisa Lough, Pertuity's head of marketing.

The rewards strategy points up a key difference in approach between peer-to-peer and traditional lending. It's in stark contrast to credit-card companies that routinely cut borrowers' credit lines and jack up their interest rates across the board, without regard for whether people have never been late with a payment, says Muhota.

Perhaps as important, the rewards program is the only way for investors to interact with the community, since they play no part in the underwriting process. Although other platforms have given lenders access to lots of data about applicants, lenders recognize that doesn't give them the credit expertise to make loan decisions, says Muhota. What investors are looking for more and more is a platform that provides risk management and a way to put their money to use as quickly as possible, he adds.