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As Peer-to-Peer Lending Grows Up, Investors Seeking High Returns, Safer Bets Jump In

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To make money in P2P lending, the trick is not to loan to one person, but rather to create a diversified portfolio by loaning to many borrowers.

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MINYANVILLE ORIGINAL If a stranger stopped you on the sidewalk and offered to pay you a 10% interest rate if you lent him or her $20,000 to pay off a credit card debt, would you do it? Many investors seeking greater returns outside of a volatile market are turning to such a concept by way of online peer to peer (P2P) lending. But, as with any investment opportunity, the hope of great returns requires risk. Here's the scoop on what the P2P market is all about, and whether it may be a worthy addition to your portfolio.

The fundamental concept of P2P lending predates the formalized banking and market structure entirely, but the online movement began around 2006 when Prosper, still one of the largest players in the space, opened its virtual doors to potential borrowers and investors. Soon after, LendingClub joined the scene. Years later, both venues continue to attract new investors searching for returns: Prospers' closed loans grew by more than 65% for the week ending September 26, 2012, compared to data for the same time period last year. LendingClub's closed loans have nearly tripled since September 2011, according to LendStats.com.

The idea behind the trend is simple: connect would-be investors to borrowers who need money for purposes that run the gamut from paying off credit card debt, to funding home improvements, to starting a business. In some cases, P2P borrowers do have less than stellar credit, but many are very credit-worthy borrowers who simply haven't found a solution via traditional financing.

In a phone interview, LendingClub Chief Marketing Officer Scott Sanborn described his site's average borrower: average FICO score of 716, aged early to mid thirties, individual income of $69,000, and an established credit history of about 12 to 14 years. He says that as many of 70% of LendingClub borrowers are seeking loans in order to pay off high interest credit card balances that they racked up in their younger years.

To validate that borrowers' claims are fact, both sites require the completion of online loan applications and access to credit bureau information. Additionally, Sanborn explains that LendingClub's process includes manual underwriting, and results in less than 10% of approved loan applications. He adds that 60% of loan applications are "flagged" for further verification, which may include requiring proof of income, or similar information from the borrower. (Prosper also offers its own so-called "3 Step Verification" process, though the site did not respond to requests for comments on details of the process by press time).

Such stringent verification and subsequent transparency is likely what has prompted so many investors to take a shot in the P2P lending market. On both sites, investors can scour for opportunity based on any number of factors, including site-determined risk grades, credit score, debt to income ratio, borrower history, and reason for the loan request, among other factors. While there's always the potential to lose money from borrower default, both LendingClub and Prosper offer a collections process (at the expense of the investor), which may or may not result in recovered funds. In the case of Lending Club, Sanborn points out that because funds are deposited directly in an investor's account when payment is made, intervention around potential payment default can occur as early as day one.
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