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by Karen Kroll, AARP Bulletin, - September 17, 2008
Jim Linebaugh, 50, was drowning in thousands of dollars in debt. He knew he needed a fresh start.
So Linebaugh, a resident of Ann Arbor, Mich., turned to VirginMoneyUS.com—after hearing about it on CNN—and After a personal bankruptcy and astronomical interest on a $2,500 loan through a payday lender, ended up borrowing $8,000 from his sister at an interest rate of 5 percent. The two agreed to terms, so there was no arguing about how much to pay each month. “We never have to talk about it,” says Linebaugh.
Virgin Money is one of a growing number of what are known as peer-to-peer, or social, lending sites. The company electronically moves the money from Linebaugh’s checking account to his sister’s account each month and reports Linebaugh’s repayments to the credit-reporting agencies, helping him rebuild his credit history. “I’m out from the burden of never feeling like I can catch up,” he says. And his sister is earning more than she was by keeping the money in a checking account.
Like Virgin Money, a growing number of companies are using the Internet to facilitate loans between individuals—family, friends and, yes, even strangers. They do this by linking, via the Web, people who need money—say, for a new car or to consolidate credit card debt—with people who have money to spare. Borrowers post an online profile to let potential lenders know how much they need and how they’ll use the money. Similarly, lenders can view different borrowers’ stories and decide who they’ll work with and what interest rate they’ll pay.
Peer-to-peer lending sites offer several advantages. As intermediaries, they remove some of the tension from the transactions. They may provide a borrower with a better chance of getting a loan from an individual, rather than from a bank, because they can offer personal history—say, details about an illness or divorce—that contributed to the borrower’s money troubles. And they make the loan official. Any time a loan is made between friends or family members, it makes sense to put the agreement in writing, says Lee Baker, a certified financial planner and president of Apex Financial Services in Atlanta. “That cuts down on the friction and gives it more credibility.”
Lenders can benefit as well. They sometimes earn more than they would with other investments and they enjoy knowing that they’re helping someone who really needs it. Prosper, another peer-to-peer site, works with individuals who don’t necessarily know each other. It operates as an online auction, like eBay. Say you want to borrow money. You place your profile on the site, telling others why you need the money, how much you’re seeking, and the maximum interest rate you’re willing to pay. You even can include a picture of yourself.
Potential lenders review the information and decide whether to lend you some or all of the amount you’re looking for, and what interest rate they’re willing to offer. They can offer as little as $50 or up to $25,000 toward your loan. During the auction period, they can bid down the interest rate on the loan. Once the auction concludes, Prosper gathers the bids with the lowest interest rates and combines them into one loan for you.
On the other side of the transaction, John Seksay, a 61-year-old educator based in Indianapolis, uses peer-to-peer lending as an alternative to investing in stocks or bonds. He’s earning about 11 percent on the $11,500 he has lent through Prosper to a variety of people. “I’m really pleased, because the stock market is nowhere near that,” he says. That’s not to say Seksay ignores risk: He lends only to borrowers considered “conservative” by Prosper. Moreover, he lends only from his disposable income. Even if he lost it all, Seksay says, he still has enough money to cover his bills.
Prosper charges borrowers a one-time fee of 1 to 3 percent of the loan, depending on their credit history, and also charges the lender 1 percent of the loan’s unpaid balance annually. All Prosper loans must be paid off within three years. Its current net default rate is 3.83 percent. The company uses a collection agency if the borrower stops making payments.
Virgin Money focuses on loans between family, friends and business associates. CEO Asheesh Advani says that because the company documents the terms of the loan and collects the money, the borrower feels more incentive to pay and the lender isn’t faced with pleading for his or her money back. Having a set repayment schedule also helps to alleviate arguments that can occur if, for instance, the borrower wants to take a vacation and the lender feels the money would be better spent paying down the loan. For its services, Virgin Money charges $9 per month, plus an initial fee between $99 and $699, depending on the loan’s complexity.
Laurie Moore, 48, is using Virgin Money to help her collect $7,000 she lent to a friend early in 2008, who never started making payments. “I’d get a lot of ‘next week, tomorrow, and the dog ate my homework,’ excuses,” Moore says. “I wasn’t going to starve if I didn’t have it, but $7,000 goes a long way when you invest it.”
Somewhat surprisingly, it was the borrower who actually suggested using Virgin Money. Moore says with a laugh that he probably tired of dealing with her calls. They set up the loan with 10 percent interest and a $250 late fee. Even with the new agreement in place, he missed the first two payments. With Virgin negotiating, Moore agreed to defer those two, but she maintained the late fees. “They’re playing interference for me. It’s fabulous,” she says.
It’s also much less time-consuming than heading to small claims court to try to collect. After 20-plus years as a paramedic, Moore is back in school in a physician’s assistant program. Between classes and an internship, her workweeks can hit 90 hours, giving her little time to chase down her money.
While these lending sites tout their ability to facilitate loans between individuals, most actually involve a financial institution on the lending side. The loans originating on Prosper, for instance, are made by WebBank, a Utah-chartered bank.
This benefits both borrowers and lenders, says Catherine Ghiglieri, a banking expert and founder of the consulting firm Ghiglieri & Co. in Austin, Texas. With a financial institution involved, federal and state banking laws, such as the Truth in Lending Act, apply to the transactions. For the bank’s part, Ghiglieri says, websites offer another way to reach potential loan applicants.
Even with bank involvement, both borrowers and lenders need to use common sense before entering into a transaction. Lenders should diversify by spreading the money they can lend across multiple borrowers, says Prosper CEO and cofounder Chris Larsen. And they need to bid the right interest rate for the risk. His company provides an estimated return on each loan that prospective lenders can see before they place their bids. According to Larsen, most Prosper loans carry an interest rate between 7 and 25 percent.
Of course, such loans are not perfect.
For borrowers, “they are both good and bad,” says Gerri Detweiler, credit adviser with Credit.com. They offer an opportunity to get more attractive interest rates than you would with other loans. That’s important, especially when the need is urgent—say for medical bills or roof repairs. However, Detweiler says, you may still end up with a high interest rate on a loan that you really shouldn’t be taking on. You could be just digging your hole deeper.
For lenders, such loans aren’t without risk. Financial expert David Yeske, founder of the wealth management firm Yeske Buie in San Francisco, says many individual lenders aren’t charging enough to cover the risk that the borrowers will stop making payments. He predicts rising default rates as the economy continues to tighten. And Apex’s Baker shares a similar sentiment: You don’t want to lend money you can’t afford to lose, he says.
But, if you’d like to make a loan and can afford the risk, peer-to-peer lending sites add structure and credibility to the process—and can help a brother like Jim Linebaugh get through rough times. “It’s hard for family members to just hand over a chunk of dollars, and it’s hard to ask for it,” Linebaugh says. “This makes it a little less emotional.”
Karen Kroll is a financial writer based in Minneapolis.
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