person-to-person lending

Prosper and Zopa have emerged with a fresh new idea: person-to-person lending. The basic idea is as follows: borrowers register with the site, have credit reports taken, then post their request for an unsecured loan, with some interest rate cap and a description of their situation. Lenders, who are also registered with the site, can then bid the lowest rate they’re willing to accept to loan to this person. Lenders can loan small amounts to many people, and the system will deliver the proper fraction of the payments to the proper lender.

The idea is certainly commendable: open up the personal loan markets to ordinary people, instead of keeping all the goods in the banks. In theory, this should improve the efficiency of this market significantly and make the world a better place. I’m pretty optimistic.

The biggest drawbacks I can think of:

  • no IRA accounts for lenders — In the current situation, lenders have to pay taxes on all interest income as if it were ordinary income. This situation may be worsened by the following: for higher-risk loans, lenders diversify by lending small amounts to many places. When some significant fraction of these default, the lender has lost that fraction of their returns. But can they deduct this loss on their taxes? Not sure. I see no reason that IRA and other tax-advantaged accounts for lenders should be impossible.
  • it’s not easy — One of the big advantages of the bank way of doing things is that banks have professionals poring over loan applications deciding which ones to fund. Individuals can’t be expected to gain the same level of expertise. This could lead to a bad reputation for person-to-person lending as a dangerous place for your money. On the other hand, this may really open the doors for new small lending firms to pop up all over the place and get started. These firms could then become experts at lending on these sites; at which point the system is similar to before, but different in that a huge pool of loans and lenders compete in the same marketplace, instead of having a bunch of disconnected markets.

It will also be interesting to see what this does to the credit reporting systems. It’s not clear that credit scores will be sufficient for judging risk in these marketplaces. Perhaps this will shed light on inefficiency in that area as well, and we will see better credit rating systems emerge soon.

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