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Social lending has potential for problems

January 15, 2008

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Person-to-person lending, or "social" lending, is growing at a phenomenal pace on the Internet as consumers look for an alternate way to pay off debt, according to new research by Javelin Strategy & Research. Javelin predicts that the demand for person-to-person lending services, or P2P, to pay off credit card debt may grow from $38 billion to $159 billion during the next five years.

While many people see opportunities to get cash that might not otherwise be available to them and lenders see a way to deploy some of their extra cash, participants in this emerging form of lending should heed several caveats.

I certainly understand the appeal of utilizing the services of such companies as Prosper or Virgin Money USA. Often, especially in the current lending market, it's hard if not impossible to get small, unsecured loans.

Prosper works much as eBay does, except instead of people listing consumer items, Prosper brokers consumer and business loans. Virgin's business model differs from Prosper in that it helps manage loans only between family and friends.

The top reason consumers said they would use a person-to-person loan is to get a better interest rate. In Javelin's survey, 36 percent of borrowers said they had used the service for the better interest rate.

Higher-income and younger consumers are the most active users, but Javelin predicts the appeal will widen as social lending opportunities increase.

Borrowers benefit from this social lending trend. They can formalize lending agreements and often get a rate better than at a financial institution or pay off higher interest credit card debt. Lenders also get a better rate than they might receive depositing money in a high-yield checking or savings account.

But I see a lot of downsides, as does Jean M. Garascia, an associate analyst with Javelin and author of its report.

"For lenders there is always the issue of default - will someone get paid back," Garascia said.

People may be lured by the promise of better rates earned on their money without carefully considering the higher risks of this direct lending. Even with documentation, the default rate is higher than what financial institutions experience.

And when you add in a personal relationship, lending to a family member or friend can be fraught with problems. Will parents be willing to foreclose on the house where their daughter and grandchildren live?

There's also the issue that people are turning to P2P lending more often to pay off other debts. In my experience, it's far better to cut expenses, increase your income or both to pay back consumer debt than to try to borrow more money, even at a lower interest rate. Further, many people are borrowing for things they should be saving for, such as vacation.

If you do consider formalizing a loan with a stranger, relative or friend by using one of these online services, please heed what Garascia said: "It's important for both lenders and borrowers to be realistic about their finances and be honest about how much they are willing to lend/lose/borrow/afford."

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