How Peer-to-Peer Lending Is Changing the Way We Borrow Money

Tired of sharing a single bathroom with his teenage son, Sean Rosas hatched a plan. He would rent out their San Francisco house for a premium thanks to the Bay Area’s booming real estate market and use the extra income to help pay for a bigger place. But attracting renters would require renovating their broken-down bathroom–and a project like that would cost more than what Rosas, the director of volunteer services at a nonprofit, had on hand. Tapping his credit card would mean paying high interest rates, while going to a bank for a loan could take weeks without any guarantee that he would be approved in the end.

That’s when Rosas, 43, stumbled on Lending Club, a website that matches borrowers directly with individual lenders. If you need a loan, the site pulls up your credit score, vets your application within minutes and assigns an interest rate. If enough people sign up to lend, you can get the money in days. More than 250 people chose to back Rosas, giving him a three-year, $16,000 loan at 8.9% annual interest. Rosas, who has made every monthly payment so far, is thrilled with his deal. “It was a much more human experience than if I had gone to a faceless bank,” he says.

Which is precisely what Silicon Valley wants you to think. Over the past decade, these kinds of loans–known as peer-to-peer lending–have evolved from a novel idea to an estimated $9 billion industry set on upending the way consumers borrow. Well-funded startups like Lending Club and Prosper function as digital middlemen, connecting people who want to lend money for profit with people who need to borrow it. Their pitch: expect lower rates than a credit card, better returns than a savings account and fewer hassles than a bank loan.

At the outset, peer-to-peer was aimed at individual lenders just as much as their borrower counterparts–one more disruptive brainstorm from the sharing economy. After all, if you’d consider renting out a room to a stranger on Airbnb, why not lend your cash the same way and rack up a profit? (The short answer: You might not get your money back.)

For all the power-to-the-people hype, the lending side of the equation is increasingly becoming the province of Big Money. Goldman Sachs, the Wall Street giant, recently said it plans to offer direct loans to everyday consumers through an app or website. Large institutional investors like hedge funds and community-bank networks are snapping up peer-to-peer loans in huge batches. And major firms such as Credit Suisse and JPMorgan Chase have invested in one of the major peer-to-peer players–at least in part because the threat to traditional retail lending is clear.

“Silicon Valley is coming,” JPMorgan Chase CEO Jamie Dimon wrote in his 2014 letter to shareholders. “They are very good at reducing the ‘pain points’ in that they can make loans in minutes, which might take banks weeks.”

But if the 2008 financial crisis taught one lesson, it’s this: Beware of the hot financial product. Peer-to-peer has grown partly as a response to the recession; when credit was tight, traditional banks pulled back on lending, and consumers needed alternatives. The appeal for borrowers is straightforward. But it’s more complicated for would-be lenders, who shoulder the bulk of the risk. Skeptical analysts warn that another financial downturn could lead peer-to-peer borrowers to default and lenders to pull back, creating a crippling cycle.

“This is classic creative destruction,” says Richard Bove, an analyst at Rafferty Capital Markets. “The potential opportunity in peer-to-peer lending is matched only with its staggering potential risk.”

Compared with a traditional loan application, Lending Club is blissfully easy. To qualify, borrowers need only an active bank account, a minimum FICO credit score of 660–the approximate subprime cutoff point–and at least three years of credit history. A proprietary underwriting algorithm approves or rejects the loan on the spot.

On the surface, lending might seem just as simple. Prospective backers can create a Lending Club account and fund it through a bank transfer. They can choose loans to fund individually or set parameters regarding loan size and risk and let Lending Club’s systems assign the funds automatically. But while it’s tempting to view that activity as lending–the natural flip side of borrowing–what’s actually going on is more complex. What lenders are really doing is investing: they’re putting their money in notes backed by the prospective repayment of loans. The sizes of the loans range from $1,000 to $35,000. Investors can buy notes in increments as small as $25–which means they can purchase small slices of lots of different loans, spreading the risk around.

The payoff: respectable investment returns. Since its founding in 2006, Lending Club has delivered investors an average annual return of 7.79%–appealing at a time when three-year Treasury bonds average 1%. “It’s absurd that in an age of technology and an age of computers, people put their money in the bank and get essentially zero back,” former U.S. Treasury Secretary Larry Summers tells TIME. Summers, who is on Lending Club’s board and has equity in the company, adds, “They borrow money on a credit card, and they pay 18%. Surely there’s a better way.”

More and more people agree. Lending Club, which went public last year, facilitated almost $1.3 billion in new consumer loans in the first quarter of 2015–a 268% jump over the same quarter in 2013. It took Prosper eight years to reach $1 billion in total loans. Fifteen months later, the company passed $4 billion. “I don’t think anybody should be confused–this isn’t a village coffee klatch,” says Summers. “This is a very serious business that is going to, over time, challenge some of the world’s great financial institutions.”

Despite the growing involvement of big financial institutions, some see the social-network element as key to this growth. “For a prior generation, when you made financial decisions, you asked your parents or you paid some financial advisers or relied on whatever your company suggested for your 401(k),” says Heath Terry, a Goldman analyst who tracks the social-lending industry. “These are a lot of things that the current generation has really lost trust in. But they do trust their peers.”

Skeptics say it’s too soon to declare the revolution. “Something tells me things are too rosy,” says Paul Christensen, a professor of finance at Northwestern’s Kellogg School of Management. He points to Lending Club’s and Prosper’s great timing: their businesses matured as the economy recovered from the recession, and they have yet to experience a severe slump.

The risk for lender-investors is undeniable. The average percentage of Lending Club borrowers with delinquent credit history has risen steadily in the past two years, from 13% in 2012 to 20% in the first quarter of 2015, according to Compass Point, a research and trading firm. Such trends led Compass Point to put a “sell” rating on Lending Club stock. And if a borrower defaults, Lending Club still receives its up-front transaction fee of 1% to 5%–which critics say is an incentive to issue as many loans as possible.

Lending Club responds that it needs to keep defaults down to stay in business. “If investors don’t have a good return, they will put their money elsewhere,” says CEO Renaud Laplanche.

On that score, Laplanche hits on a fundamental truth about the sharing economy: community may be part of the appeal, but–as with anything in the world of financial services–the point is making a profit.