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Peer to Peer Lending - Using the Internet to Facilitate Lending

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Peer to peer lending is a way to borrow money without involving a financial institution. Also known as "person" to person lending, "lending clubs", and "social lending", this type of financing matches investors (as lenders) with other individuals in need of small loans.

What is Peer to Peer Lending?

The original peer to peer lending meant going to Uncle Bob to borrow money, or finding a wealthy business partner to help finance a new opportunity. Although these types of "person to person" home-based borrowing still exist, a whole new arena of private lending has sprung up in recent years. Today, peer to peer lending is widely used to refer to any type of financing that directly connects individual borrowers with individual lenders to arrange small, short-term loans.

Most of the "matchmaking" aspect of peer to peer lending takes place online. There are dozens of reputable websites that connect lenders, with the objective of receiving a nice return on investment. Borrowers have embraced this method of financing as a way of securing a loan without the red tape and high interest rates required by many traditional banks.

How Lending Clubs Operate

For many people, especially those with less than perfect credit, a lending club is an easier way to secure a loan than navigating banking institutions' credit checks or paying the steep interest rates demanded by high-risk lenders. Online peer to peer lending groups require a credit check, but prospective lenders won't be able to see everything in your credit history like a bank would. In some cases, you can increase the likelihood of procuring a loan by offering detailed information about employment, income, and home ownership, but it isn't always required.

That said, your chances of receiving a loan will depend not on the formulas used by conventional banks, but on the individual comfort level and preferences of the lenders using that site - real people, who may or may not decide to lend money to any given applicant.

Social lending websites operate like a financial version of eBay. Prospective borrowers upload their credit information and the amount of their desired loan, and lenders bid on the loan by offering the interest rates they're willing to extend. Some sites process a borrower's information and automatically generate an appropriate interest rate before giving lenders a chance to offer to loan money at that rate.

Advantages and Disadvantages

Thanks to the convenience of peer to peer lending websites, access to a small loan has never been easier. Social lending can be used intelligently, to secure lower rates than might otherwise be possible or to finance investments or opportunities. But in many cases, peer to peer lending can be risky for both borrowers and lenders.

If your credit score is low, interest rates can be as steep as 35% annually, making it difficult, if not impossible, to repay the amount of the original loan plus interest. Even a more modest rate of 10-15% - not unheard of for mid-range credit scores on peer to peer sites - is on the high side relative to conventional loans. If you're interested in securing a lower interest loan to pay off a credit card that's currently charging around 20% interest, these terms are definitely an improvement, but other borrowers should think twice before agreeing to the escalated rates offered on some peer to peer lending sites.

Social lending groups fill an important niche, allowing borrowers to connect directly with investors without the banking institution acting as a "middle man". However, borrowers should be cautious of the steep interest rates that can come with peer to peer lending.