investing

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

Jim Bruene, editor and founder of Online Banking Report, says judging which borrowers are good risks could still be a tricky situation for lenders. In a report on online lending, Bruene noted that while the credit grade and pre-housing debt-to-income ratio is disclosed, Prosper lenders can't count on having all the information that's available to banks. Among other things, Bruene points out that lenders can't be confident that income has been verified because it's self-reported.

"They get the credit score, and you can gauge a lot of the risk -- it's not something they invented," Bruene says. "But the biggest concern I have is fraud. How many of those people are making fraudulent applications? How many are using someone else's ID? Or about to go bankrupt so they're grabbing as much money as they can before they go bankrupt?"

Zopa began person-to-person lending in the United Kingdom in March 2005 and expects to begin the service in the U.S. sometime in 2006. CEO Richard Duvall says the company strives to weed out the bad apples.

"In the U.K. we provide a guarantee that if they lend to someone who doesn't exist we take full responsibility, and we expect to do the same thing in the U.S. In the U.K. we've had one fraud get through our system. That's out of 90,000 members. We have very sophisticated systems."

Spreading the wealth

To help avoid losses to lenders, Zopa and Prosper let lenders limit their exposure by spreading their money around. If you have $5,000 to lend, the companies enable you to make 100 $50 loans. In the event a borrower defaults, both companies report the default to debt collection companies.

Phil White, a financial adviser in San Antonio, has made 35 loans on Prosper, funded by about $6,000.

"I started with $500 in principal and phased more in as my comfort level increased. My loans have ranged from $50 to $550, and my average interest rate is 20 percent. Borrowers have been late with payments a couple times, but no one has defaulted yet.

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"When I worked for the JPMorgan Private Bank, we would help our clients target asset classes with low correlation to the overall equity or fixed income markets. Their net worth, which was typically greater than $25 million, afforded them access to hedge funds and commodity trading advisers that generally carry high minimums. Investing in the Prosper marketplace looked like an opportunity not correlated to the general markets."

If delving into the consumer credit market in this fashion appeals to you, be prepared to spend time researching borrowers. This isn't like buying a CD with a click of a mouse or a quick trip to the bank. If you feel comfortable lending to borrowers with a certain credit grade you can create a "standing order" by selecting the credit grade, the interest rate you desire and noting how much money you want to lend. The system will then place bids for you on loans that meet your criteria. But it's probably best to study several loan requests within various credit grades before shifting to automatic pilot.

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