investing

Person-to-person lending: High return, but risky?

Yields on certificates of deposit, or CDs, may be in need of an injection now that the Federal Reserve appears to be winding down the rate hikes, but that doesn't mean high yields are a thing of the past. Fixed-income investors who are willing to take on some risk -- and devote some time to research -- may want to explore lending in the consumer credit market.

In the traditional scenario, you give money for a CD to the bank and the bank gives you a guaranteed interest rate. The bank then lends your deposit to a customer who needs a loan, but at a higher interest rate. What if you could find that person in need of a loan, lend him or her the money yourself and charge a better rate than you could get on a CD?

No, we're not talking about lending money to a relative who howls about paying interest and drags his feet when payment is due. So-called person-to-person lending is not without risk, but it's light years ahead of an IOU from cousin Bernie.

At least two companies are banking on person-to-person lending becoming a viable alternative for individuals who would like another way to earn high yields.

"In the past, if you had money, you didn't have any other choice than a bank and putting your money in an account. You were closed off from the consumer credit market," says Chris Larsen, CEO and co-founder of Prosper.

"You may be earning 5 percent on your savings at ING, but your neighbor is paying 15 percent on a credit card balance, and you may be thinking: Why can't I lend to him and earn a better rate? This allows you to do that for the first time."

A money middleman

Prosper, which started in February, bills itself as "America's first people-to-people lending marketplace." Folks who want to borrow money create a loan listing for up to $25,000 and set the maximum interest rate they're willing to pay. Lenders deposit whatever amount they're willing to lend into an account, peruse the loan listings and bid on ones that appeal to them.

Prosper essentially acts as a middleman, handling the loan structure and payments. The borrower pays a lump sum to Prosper each month, and Prosper divides the payments among lenders and deposits them in the lenders' bank accounts.

Prosper makes its money by charging fees to lenders and borrowers. Borrowers pay 1 percent of the amount of the loan, and lenders pay a half percent annual loan servicing fee.

Larsen, who also co-founded E-Loan, says Prosper currently has about 70,000 registered users and $16 million in the marketplace, with $14 million loaned out to approximately 3,000 borrowers. He estimates that 9,000 lenders are bidding on loans.

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"When a borrower makes a listing we take them through the same checks as a bank or credit card company would," says Larsen. "(We) weed out the frauds and the identity problems. We originate the loan and handle the disclosures. It's important that lenders don't have to worry about having a license or giving disclosures."

"We pull the credit file and (set up) the loan payments, but we don't make the credit decision. Once we validate (a borrower) we assign a credit grade and give some other information that helps lenders make credit risk decisions. The lender's objective is to value the person's loan request."

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