What financial advisors need to know about peer to peer lending Article added by Amy McIlwain on July 14, 2011
Amy McIlwain

Amy McIlwain

Denver, CO

Joined: August 26, 2010

Peer to peer lending, also known as person to person lending and social lending, is a specific type of financial transaction that occurs between individuals without the intermediation of a traditional financial institution.

The word “disintermediation” is not very common in a financial advisor’s vocabulary. Typically, financial advisors work with intermediaries like banks and other financial institutions when managing their client’s finances. I mean, a financial advisor is an intermediary in and of itself — they act as the middle ground between a client and their finances.

So what happens when a financial phenomenon starts to take over the social media world that essentially removes the need for an intermediary? The loan and investment service known as peer to peer lending is changing the financial lending landscape in drastic new ways.

What if I told you your clients could borrow money from a complete stranger, receive better interest rates than what most banks offer, and give the lender the opportunity to yield higher returns, all within a much shorter time period than the average loan and investment process?

This is exactly what peer to peer lending does, and it’s a growing personal and business venture that’s causing financial advisors to take another look at its pros and cons.

Before delving into whether peer to peer lending is appropriate for your clients, let’s first discuss what it actually is. Peer to peer lending, also known as person to person lending and social lending, is a specific type of financial transaction that occurs between individuals without the intermediation of a traditional financial institution.

What’s interesting to note, especially for us social media nerds, is that peer to peer lending is a direct byproduct of Internet technologies. The development of peer to peer lending grew exponentially during the global economic crisis between 2007 and 2010, when banks and other traditional financial institutions were experiencing fiscal difficulties and were unable to promise credit to borrowers. It has also grown in popularity among those individuals carrying a bad credit score and unable to receive loans from banks and traditional financial institutions.

So, what’s the catch? Why is peer to peer lending such a growing venture? One word — the word that you probably don’t hear very often — disintermediation. Like we’ve already discussed, disintermediation is a term that describes the removal of intermediaries in a supply chain, or in this context, the removal of traditional financial institutions between individuals.

Doing so results in a drop in costs for servicing customers. It is important to point out, however, that as the peer to peer lending process develops, and more and more peer to peer companies that provide customer service, arbitration, product information and quality website management are created, we will see a reintermediation, much like the banks and traditional financial institutions we have been discussing.

Furthermore, it is not crazy to foresee the reintermediation of peer to peer lending from financial advisors themselves — that is if advisors jump into the game and start playing for their clients.

As far as peer lending companies go, there are numerous businesses out there, but the biggest are Prosper and Lending Club, who jumped in the game early on and have banked on the growth of peer to peer lending.
These two market leaders not only have investor backing, but Prosper is approaching over $200 million in originated loans, with Lending Club close on its heels at $100 million. Think of these companies like a loan auctioning eBay website. Individuals looking to borrow money can go to the website, enter the amount of the loan, and in turn receive possible interest rates from different investors.

Conversely, individuals interested in investing can invest as little as $25 per borrower, with the intent of small risks invested in a spread out, well-diversified class of borrowers. Welcome to the new portfolio asset class.

But is at as good as it seems? Financial advisors and investment specialists should caution their clients in considering peer to peer lending. Why? Here’s a list of pros and cons to each:

The elimination of a third party makes the process quick and easy. High risk of loan default, with little recourse for non-payment.
Auction-like style of borrowers offers the lender the ability to choose own terms and rates.Peer to peer loans are not subject to the same financial regulations as banks, so the loans may not be as favorable.
Lenders can enjoy higher returns, and borrowers enjoys similar cost advantages.Peer to peer loans can hurt your personal credit score.
Less discriminate than banks. After the bank collapse, banks are cutting back on loans and upping financial requirements.Less discriminate than banks, which means you may be loaning money to an individual unable to repay the loan.

As you can see, peer to peer lending has its definite advantages and drawbacks. Investors should be extremely wary about recommending peer to peer lending to their clients, and if you do, make sure you’re doing your homework.

Develop a comprehensive system of investing in borrowers based on information that is available about the borrowers. Make sure to do some in-depth research on peer lending companies too. They’re sprouting up all over the place, and you want to give your clients the best options.

Of course, peer to peer lending would not be possible without the existence of social networks. With that said, I can’t help but ask this question — will top social networking platforms buy in to the flourishing peer to peer lending market and become banking institutions in and of themselves?

Imagine Facebook, the number one social networking platform that boasts over 500 million active users, becoming a Bank 2.0. It could happen. And even the thought of it is changing the future of financial services. The evolution of social networking sites and peer to peer lending companies is a concept that will hopefully drive the financial industry a little further into the social media world.
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