Social lending platforms: new opportunities, but with some risks
Not only start-up entrepreneurs, but small and medium sized business owners the world over have experienced first-hand, exactly how challenging it can be to obtain financing. Even now, more than 5 years after the recession caused by the Great Financial Crisis, most SMEs cannot borrow easily, if at all, from their local bank.
At the same time, however, the internet and fintech are facilitating and supporting the emergence of newer types of lending platforms. While not without risk, these platforms are already opening up more opportunity for SME business expansion, which is desperately needed by the main engine of growth in every functioning economy.
So what is a social lending platform, and how does it differ from traditional lenders, including banks and building societies? The first social lending platforms were established in the US – not too surprisingly given the existence of Silicon Valley, and given that the US has monetized the power of the internet more successfully than anywhere else.
The operators of a social lending, or Peer to Peer (P2P) lending platform as it is also known, provide an online-only service of matching borrowers and lenders. The typical service is delivered for a relatively small fee, which frequently involves a transaction charge and a percentage of the interest paid. And of course, the banking intermediary is removed.
A couple of the bigger and longer established players in the industry are Prosper Marketplace and Lending Club. Billions of dollars in loans have now been issued on these and other similar platforms. Initially the aim of P2P lending was personal use loans, but nowadays lending is for a variety of uses including SME business loans.
For the borrower, kicking off the process is as simple as filling out an online form to determine eligibility. Eligibility will depend on credit worthiness, and the background of the borrower – an applicant with a steady job always looks good!
Assuming the potential borrower gets the go-ahead, he or she can then check what kind of loan is possible, and the terms, including period and interest rate applied. If he or she makes the decision to put in an application for a loan, there is usually a minimal waiting period of a day or two at most, the relevant financial documents are all online, and the money arrives a few business days later. None of this would be even conceivable for a bank.
Interest rates in most peer-to-peer marketplaces range from as low as 5% up to over 30%, and both credit quality of the borrower and the purpose of the loan will normally be taken into account. Prosper has a $35,000 loan amount cap on its loans, while with some companies in the industry, P2P business loans for amounts of up to $300,000 are available.
One of the benefits of social lending is that lenders compete for the opportunity to fund a loan. When a borrower submits an application, there will likely be several lenders making funding offers at different interest rates. This ‘bidding’ process ensures the best possible terms for the borrower.
In many cases the terms will actually be substantially better than those offered by a bank or commercial lender for SME financing. When a borrower has established a good track record of borrowing and making the repayment on time, it will become easier to take out another loan on the platform, and the terms offered by lenders will improve.
For the lender, social lending platforms are an opportunity to earn a higher level of interest than on a regular deposit or savings vehicle. All of the major P2Ps carry out background checks on borrowers, and continually review borrower performance. The site provides potential lenders with access to a borrower's financial data, as well as any previous transaction performance data, before they make the loan.
Once a loan is taken out, scheduled interest payments and principal repayments are made directly through the secure online management system on the website, and lenders can monitor the loan payments online.
There are 2 major risks to borrower and lender considering P2P lending. The first is obviously the ‘unknown’ borrower and ‘unknown’ lender. The vast majority of loans are unsecured. While the probability of either party failing to live up to the loan agreement may be low, it is not negligible.
The second major risk is lack of full regulatory protection. Unlike the global banking sector which is obliged to conform to ever increasing global regulation, P2P lending is not globally regulated. Indeed, in some countries, it is not regulated at all, while in others, it is regulated out of existence!
Clearly over-regulation is not a good thing, but protection of consumers is. When comparing P2P providers, a regulated entity will always give you relatively more protection. Therefore, before embarking on any financial adventure in P2P lending, make sure that you are fully aware of what protections and rights will be guaranteed.