With the increasing scarcity of bank loans because of the economy's credit crunch, entrepreneurs are thirsty for new sources of capital. One such alternative is peer-to-peer lending, in which people lend other people money directly, without the involvement of a financial institution. Transactions take place online, incorporating elements of social-networking sites. Websites such as Prosper.com and Kiva.com connect borrowers and lenders, and the prize on the table is investments.
Peer-to-peer lending sites tap into the popularity of social networking on the Web, hoping to imitate the success of MySpace and Facebook. But there is concern that these sites could fizzle out in popularity, as many Web start-ups do.
If you're looking for a loan for your start-up, is peer-to-peer lending a good source? Paul Dholakia of Rice University's Graduate School of Management recently published a study analyzing Prosper and the peer-to-peer lending phenomenon in general. We talked to him about how this form of lending differs from traditional ones, and how it may be "democratizing" finance.
What do we know about peer-to-peer lending in terms of what the loans are used for?
Motivations of the borrowers are definitely an important issue. Because we spent a lot of time sifting through these loans, I have a pretty good sense. I would say a good 25 to 30 percent are requests to start new businesses. That is a huge part. People are trying to fund businesses they just started and are looking for more capital. It's probably one of the biggest categories, if not the biggest category. Another big category is people who are looking to pay down their debt. Is peer-to-peer lending getting a boost due to the credit crunch, or is it becoming more known and accepted as this industry develops?
A lot of people would rather go to their own bank because of comfort. But a lot of people who are discussing personal finance and peer-to-peer lending on blogs and discussion groups—there's just as much awareness now even compared to a year ago. A lot of these borrowers' options are limited. They can't turn to traditional lenders. This looks like a very appealing opportunity for borrowers, but also for lenders. They're able to do something nice, get a good return on their investment, and participate in this society. An important part of the study looks at how Prosper and other sites like it might be "democratizing" lending. What do you mean by that?
Look at what economic theory would prescribe: In theory, investors should pay no attention to demographics and only care about financial returns. One of the main things we wanted to look at is what demographics are participating [in peer-to-peer lending] in terms of gender, race, and things like that. One of the things we speculated is that lenders would be much less biased or prejudiced in terms of stereotyping. Because people are lending their own money, they're going to be much more rational in their decision making. They're going to focus on financial information, like debt-to-income ratio [rather than stereotypes]. What we found is that the lenders [in peer-to-peer lending] do behave very rationally, and demographics play a very minor role. The point is that if you are a minority or female entrepreneur, you might get a much fairer place to seek funding. This is a situation where the lenders are putting their own money on the table, so they're making decisions on very rational terms. What about the criticism that these sites will just become full of bad loans that the borrower never intends to repay?
There's this huge social community attached to this website. Let's say I'm this subprime borrower and...I just want to scam some people and get some money off them. It's not like I can just go onto Prosper and list my loan and people are just going to throw me money. That's when the community comes into play. The lenders are basically the policemen and women of the website. They have a lot of discussions. Borrowers have to spend a lot of time and effort in convincing the lenders and creating trust. And this happens in a very informal way through the discussion forums and so on. It really reduces the possibility of fraudsters and scamsters taking over the site. You might have a borrower who has the highest classification on the site. You find that that person spent something like six months on the site chatting and making him or herself known and winning the trust of the community. The lenders are perfectly happy to lend at a discount rate to someone who they think deserves a chance. So how is that different from the kind of safety measures they have in place at eBay?
On eBay, buyers have to maintain their reputation by being honest. On Prosper, reputation doesn't make much sense. Most of the loans are one-off loans. Compare the power of the community. The community is going to be much more powerful in the Prosper case. The community must substitute for the reputation mechanism. On eBay, the community plays the role of education and providing information to new sellers. But there's not the same controlling element and vetting element that we've seen on Prosper. What advice would you give to someone who does not know about peer-to-peer lending but might want to get involved as a borrower?
You need to integrate yourself into the community. If you're looking for quick money, you're not going to get it. Your personal finance, the details of your project, what your budget is, how much money you make—that's all information that the lending community absolutely wants from you. So unless you give all this information and spend maybe a month or two months with the lending community, the chances of success are small, regardless of your credit rating. How has the rate of return been?
A lot of the initial lenders were very risk-seeking. They had no problem loaning a lot of money to high-risk borrowers. I'm sure many of them lost money. This is a very new business model, so obviously there are going to be some mistakes. They've had to adjust their lending strategies. Many people made mistakes, and I don't know if they all learned from it. The company is responding to calibrate the risk for lenders. Will Prosper itself be successful? I don't know. But I'm quite confident of the concept of social lending itself—the business model makes sense, and it's going to be around for quite some time.