How Marketplace Lending Works
Online marketplace lending (Peer-to-Peer/P2P lending) platforms directly connect individuals who want to borrow money with individuals who want to lend it. Lending takes place online on marketplace lending websites where borrowers submit their applications for loans. Personal and institutional investors can then partially or fully fund these listings by specifying the amount they want to provide. When the total amount requested by a listing is fulfilled the listing becomes a loan.
P2P lending from borrower’s perspective
Let’s take an example of Lending Club, the largest US marketplace lending platform. A borrower that comes to Lending Club webpage is prompted to provide the amount of money they would like to borrow, state the purpose of the loan (e.g. credit card refinancing), and provide an approximate range of their FICO score. A borrower is also asked to provide some additional personal information (e.g. address, date of birth, annual income, in some cases SSN). This helps Lending Club verify borrower’s credit history report provided by credit agencies.
Following the credit check and assuming that the borrower meets basic eligibility criteria, the borrower gets various loan offers. Borrower is able to select between various loan terms (36 or 60 months), monthly payments, APRs and interest rate options. A borrower selects a loan offer that best fits their needs and is required to provide some additional information about income, employment, and SSN. The loan listing is then posted online and can be funded by investors. If the amount requested gets funded, the loan is automatically deposited to borrower’s bank account. The entire process of getting a loan typically lakes about 7 days. Applying for a loan through a marketplace lending website does not affect borrower’s credit score and generates a soft credit inquiry. A soft credit inquiry is visible to borrower only and not to creditors or other users of the credit report.
P2P lending from investor’s perspective
After setting up an investment account with marketplace lending platform and transferring money to it, an investor can start browsing through listings available for investment. For each loan listing an investor can learn more about the borrower’s loan purpose, check the assigned loan grade, term, amount, and view information about borrower’s credit history, e.g., credit score range, number of open credit lines, number of delinquencies in the last 2 years, revolving credit balance, and more. Based on this information, an investor can decide how much money to allocate to each of the borrowers.
On Lending Club platform, the lowest amount that one can commit to a loan listing is $25. Generally, it is recommended that the investor diversifies the portfolio, i.e., invests small fractions of the budget into multiple fractional loans that correspond to different borrowers. By doing so, an investor exposes himself to a lower risk of loss.
Stay tuned! In the blog posts to follow we will learn how to accurately estimate the risk of the borrowers, which types of borrowers to avoid and how to structure a risk/return balanced portfolio.
Attractive, but risky investment opportunity
The process of borrowing money through an online marketplace lending website excludes a traditional financial intermediary such as a bank. In fact, the idea of marketplace lending is to disrupt the traditional bank lending and make borrowing more affordable for people. Eliminating the bank from the process of lending offers reduced financing costs, because it removes high fees charged by the banks. As a result, borrowers can receive lower interest rates and investors can get better returns compared to investing their money into a bank account.
However, there is a diverse set of potential borrowers who can apply for a loan even if they are not eligible for getting a bank loan. Investors are therefore exposed to increased risk of borrower defaults and are not protected by screening processes often performed by the banks. Marketplace lending platforms have certain underwriting criteria that the borrowers have to meet to be eligible for applying for a loan. But the majority of risk is passed on to the investors. It’s very important for the investors to be able to accurately estimate the risks of the borrowers.
Stay tuned as we discover how to accurately estimate the risk of the borrowers in the next blog posts!