Frustrated by historically low interest rates, small investors are finding that traditional financial institutions are unable to provide them with satisfactory levels of income. What if people could easily find qualified borrowers and make their own loans directly? They could earn much higher levels of interest than they could with a traditional bank and have some control over where their money goes.
Banks typically serve as a middlemen in financial transactions. They pay depositors a minimal amount of interest on their accounts and then lend the money at much higher levels of interest to their borrowers. The difference between the two rates of interest is profit.
Prosper.com offers a matchmaking service between prospective lenders and borrowers. Lenders can screen borrowers based on personal narratives, needs, and credit quality. All loans use a fixed payback period of one, three, or five years. After the initial match, Prosper administrates each of the loans – including payment collection and record keeping for an annual loan service fee of 1% (payable by the lender). It is worth noting that Prosper is not registered as a bank and loans made through the service do not receive the benefit of FDIC insurance.
So far, Prosper has matched $300 million in loans between over a million participants. Borrowers with excellent credit histories are currently paying annual interest rates of over 5%, while at-risk borrowers looking to consolidate credit card debt are paying over 20%. In order to limit risk, many lenders at Prosper set up diversified loan portfolios. Individual loans can be for amounts as small as $25. This greatly minimizes exposure to loss in case any of the individual borrowers fail to make their monthly payments.
With Prosper and similar services such as Lending Club, banking becomes a better experience. Peer-to-peer lending puts people in touch with what their money is doing. Borrowers, meanwhile, realize that their checks aren’t going to a large corporation, but to real people who are depending on them to make their payments.
The next big opportunity for peer-to-peer funding is venture capital.
Until very recently, it has been illegal to crowdfund small positions for equity stakes in new businesses within the U.S. The JOBS Act (an acronym for Jumpstart Our Business Startups), signed into law just last month, removes decades-old legal prohibitions against public advertising of private equity offerings and makes it possible for non-accredited investors (i.e., <$1,000,000 net worth or $200,000 annual income) to invest in venture capital.
The SEC still has several months to amend its rules to reflect these new changes in the law. Once this happens, though, we’ll see a revolution in the world of angel funding and venture capital. Soon it will be possible for small investors to get in on the ground-floor of many more new businesses well in advance of their first IPO. This is good news for everyone – investors, entrepreneurs and anyone else who relies on accessible capital markets. Google+