Small business owners are starting to feel the effects of the credit drought. Many may already have experienced disappointment with a loan application. Meanwhile unexpected needs for a cash injection keep coming up such as a delivery vehicle breakdown or an opportunity to pick up some normally expensive office equipment or machinery at a good price. With credit getting tighter and credit card charges going up, who can a cash strapped owner turn to for a loan?
Increasingly these days, the answer is - to a stranger. A peer-to-peer (P2P) loan (also known as ‘person to person lending' and ‘social lending') is a loan mediated directly with another person without using a bank or financial institution. Would-be lenders compete with each other on the basis of the interest rate they apply. The lender willing to provide the lowest interest rate ‘wins' the borrower's loan. The majority of these deals bring together a borrower and lender not previously known to each other. For a flat fee, P2P lenders may also perform a ‘family and friend' transaction helping a borrower and lender who do already know each other (family members or business associates) to sort out the terms of a loan arrangement and then formalise it in writing.
The process has become popular because it is mediated by the social networking capabilities of the internet. Popular P2P lender organisations, such as iGrin, LendingHub, Prosper, Zopa and Virgin Money, have become the eBay equivalent of the personal loan market putting borrowers in direct contact with lenders for loans up to around $25,000.
The allure of peer-to-peer lending goes beyond finding a willing lender charging a reasonable rate of interest. The process is not known as ‘social lending' without reason. One unique aspect of P2P lending is that it gives borrowers the chance to tell their story, so applying for a loan can be as much about winning hearts and minds through mentioning shared hobbies or interests as about a compelling business plan. At LendingClub, lenders pick borrowers based not only on their credit profile, but also on their affiliations; at Prosper, users can create groups that, based on members' repayment history, receive star ratings and can help member borrowers get lower rates.
It may be easy money but is it smart money?
The fact that money may be just a few clicks away makes P2P borrowing a very tempting proposition. But that doesn't automatically make it a smart choice. The P2P option can be used intelligently to deal with a short term cash requirement or to trade a high rate credit card debt for a lower rate P2P loan - their lower interest loans can be used to pay off a high interest credit card balance.
However, as with all financial deals, you need to understand the rules of the road if you don't want to crash.
Generally, the basic principle of lending - that the lower your credit score, the lower your chance of getting financed - applies just as much in P2P deals as it does with traditional lending institutions. P2P lender sites usually grade borrowers' credit worthiness in some way, based mainly on their credit score.
Money borrowed through a P2P lender is reported to the credit bureaus as a personal loan. Paying off $10,000 in credit card debt still leaves your credit report showing a $10,000 debt – only now it will represent your personal loan.
You haven't gained any ground in reducing your overall debt but you have lowered the interest rate you pay on the debt. That may be a good result in itself, but it doesn't improve your credit score in any way. Loans taken out to fund business activity can even reduce your credit rating. Regardless of the purpose the borrower has in mind to use the money for, it really amounts to, and is treated by credit companies as, just another personal loan. By adding this new loan to your debt, your credit score may go down. That can affect your longer term ability to get a loan from the conventional sources or even credit from vendors or suppliers.
The new P2P lending sites, as with credit cards before them, may be making it a little too easy for a business owner to get their hands on money. P2P lending obviously addresses a gap in the credit market, but such loans can hurt personal credit scores and potentially draw business owners in over their heads. Before seeking money from a P2P site a prudent business owner should sit down and take a really hard look at their financials and do a cash flow projection to make sure they can pay back the loan. Otherwise they could be making a bad situation even worse.