An Insiders Look at Peer-To-Peer Lending

Peer-to-peer lending is a relatively young area of the banking business, but its popularity has skyrocketed in recent years.

Put simply, a peer-to-peer lender is a company that serves as sort of a middleman between people who need to borrow money and investors who have money to lend. Several companies have successfully created these types of lending networks. On the personal lending side of the business, companies such asLending Cluband Prosper are originating billions in loans and growing at breathtaking rates. On the small business side of lending, Funding Circle is rapidly becoming a market leader in the U.S. after capturing a leading market share in the U.K.

Recently, I had a conversation with Funding Circle's co-founder and U.S. managing director, Sam Hodges, who offered insights on how peer-to-peer lending works, why it has been so successful so far, and what the future might hold for this rapidly growing business. As a side note, Hodges' responses are largely paraphrased.

Source: Funding Circle.

Matt Frankel: In your business model, borrowers apply for loans and investors lend those borrowers money. How do companies like Funding Circle make their money?

Sam Hodges: We generate revenue in two main ways. First, we charge an origination, or success, fee on all of the loans that are funded; typically the amount is 3% of the loan amount. Then we charge an ongoing service fee, which covers our continuous efforts to make sure the loans are performing. That fee is 1% per year, based on the outstanding principle balance of each loan.

Frankel: What are some of the risks that peer-to-peer lenders like Funding Circle face? In other words, what could potentially hurt your ability to grow and generate revenue?

Hodges: There are a few risks we face. On the macroeconomic side, interest rate spikes are an ongoing risk. If rates were to spike very rapidly, we could see borrower demand drop, which could slow down the rate of loan originations. We also have some level of analytical risk. We need to make sure our process of analyzing credit risk on potential loans is accurate, so our investors continue to earn acceptable returns on their money. And, of course, since so much of our business is automated we have some technical risk as well.

Frankel: Why do you think peer-to-peer lending has been so successful in such a short amount of time?

Hodges: A lot of it has to do with our "moment in time." What I mean is that after the financial crisis, we saw a lot of banks shy away from small business and personal lending. Plus, the number of banks in the U.S. declined from about 12,000 to 6,500 over the past decade or so. These factors created a huge opportunity.

And peer-to-peer lending simply creates a better experience for borrowers. People needed access to easier financing than banks were providing, and that's why peer-to-peer lenders have been so successful.

Frankel: Currently, peer-to-peer loans make up about 0.1% of the overall U.S. consumer debt market. What do you think is the future potential of the business?

Hodges: I think peer-to-peer lending could grow into a dominant force in the banking industry, not just here in the U.S., but all over the world. There is enough room in the market for several leading peer-to-peer lenders, each making billions of dollars in originations. Now, having said that, while it might change the banking system, it will never replace banks. Banks are an essential part of our society, and will always have their place.

Frankel: What are the perks and risks for people who might want to become investors, or "lenders"?

Hodges: Well, lenders receive the full principle and interest payment on the loans they finance every month, minus the service fee I mentioned earlier. The main risk to lenders is the risk of default, but our loan portfolio is very strong. Our default rate is about 2% per year, so the risk of any single loan defaulting is rather small.

The best advice I could give to those who want to invest is to properly diversify. We require a $50,000 minimum to open an account, and allow as little as $1,000 to be invested in individual loans. So an investor with a well-diversified portfolio can expect to receive their portfolio's average interest rate, minus 2% for defaults and 1% for our maintenance fee.

Peer-to-peer lending gives investors exposure to different types of assets than traditional equities and bonds. For example, through existing peer-to-peer lenders, investors can get exposure to small business credit, consumer credit, and real estate financing. It's an opportunity to build a more diversified portfolio of investments.

Frankel: That sounds great for the investors, but why would borrowers choose a peer-to-peer lender instead of a bank?

Hodges: There are a few advantages for borrowers. The comment I hear most often from our borrowers is that we're fast. A bank loan can take months, especially for a small business, and we can complete the lending process in less than a week. We're also much more transparent than a bank, with no hidden fees such as a prepayment penalty. Borrowers simply pay the origination fee, get their money, and make principle and interest payments as agreed. Finally, peer-to-peerlending is convenient. People have the option of when and where they want to apply for a loan. In fact, 40% of our business occurs online outside of normal business hours. We realize that time is money, and people don't always have a few hours to sit in a bank.

Funding Circle is a leading global market place for peer-to-peerlending to small businesses, and has an 80% market share in the U.K. for peer-to-peersmall business lending. Since its founding in 2010, the company has lent more than $800 million globally to small business owners.

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