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Is Peer to Peer Lending the Wave of the Future?

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In desperate economic times, it's increasingly difficult to secure a loan the "normal" way. Banks and financial institutions are reluctant to offer money even to people with perfect credit ratings, so how can someone with an average or low credit score hope to get even a small loan? The answer has arrived in the growing phenomenon of social lending, an Internet-moderated system in which consumers borrow money directly from other people.

How Peer to Peer Lending Works

Online social lending clubs allow each new member to register as either a lender or a borrower. Lenders are interested in social lending as a means of investing; some sites allow lenders to choose their own interest rates when offering loans, while others force high interest rates on borrowers with poor credit ratings. Either way, lenders are able to make a good return, provided that borrowers repay their loans.

Borrowers, on the other hand, are drawn to peer to peer lending sites as an easy way to secure a loan, even though the annual interest rates offered at social lending clubs can be extremely high - 35% or higher for those with bad credit ratings.

If your credit is good, though, peer to peer lending can be a hassle-free way to get a short-term loan without jumping through the hoops required by banking institutions. According to Slate Magazine, social lending sites have financed nearly half a billion dollars in loans in the past several years, and their popularity continues to grow.

Lending Clubs Fill a Niche Market

Lending clubs are a relatively recent development, originally formed by the micro lending movement and spurred on by the current economic struggles. The first social lending sites, such as Kiva.org, were set up to offer small loans, or "microloans", to aspiring entrepreneurs in third world countries. The idea was for lenders to offer money not only as an investment, but to support causes and people in need around the world.

Other peer to peer lending sites adopted the same model, but began to offer social lending within Western countries as well. Zopa, Lending Club, and even Kiva now offer loans to people in the United States, the UK, and other developed countries, making peer to peer lending less an act of philanthropy and more of a smart, economic investment. The borrower demographic has also changed, from hopeful entrepreneurs in third world countries to the "average Joe" seeking a loan to pay for house repairs, a new car, or his daughter's wedding.

The Dangers of Social Lending

In addition to presenting borrowers with high interest rates, social lending can also be risky for lenders. So far, reports GlobalChange.com, the default rate on peer to peer loans has been much lower than the standard rates seen by banks. Less than 0.5% of loans default payment, which means that lenders who distribute their investments across several small loans still see decent returns on their investment.

It's believed that peer to peer lending is less risky than lending money through a bank because the personal contact gives borrowers an added incentive to repay their loans - if the "bank" is your friend or neighbor, there is more personal responsibility invested in repaying the loan. On the other hand, if borrowers don't repay loans, an individual lender has even less recourse than a bank does to force repayment - and if social lending becomes too much of a risk for lenders, the financial model will fail.

Social lending is still a new and developing phenomenon, with a great deal of regulation still to be determined. It's hard to say exactly how it will develop or whether the low default rate will last. Peer to peer lending certainly has promise, though, and with good regulation and careful investment, it may become an increasingly viable source of loans in the future.