Melanie Lindner, 03.24.09, 05:15 PM EDT
Social-lending sites pair willing lenders with cash-strapped borrowers. Here's how.


Credit remains as tight as springtime sinuses. But rather than wait for the Federal Reserve's maneuvers to get things flowing again, antsy borrowers are asking their neighbors for a little help online, thanks to a rash of so-called social- lending Web sites. These operators charge fees to broker and service the loans--about 1% from the lender and 2% to 4% from the borrower--as well as penalties for late payments to cover the costs of chasing deadbeats.

While still tiny, the social-lending business is gaining serious momentum. The dollar amount of outstanding loans jumped 41.7% in 2008 to $102 million, according to Jim Bruene, founder of Seattle-based NetBanker, which tracks the online finance world. Bruene figures that figure could hit $1 billion by 2013.

Credit that growth to locked-up credit markets--and potentially rich returns for lenders. While social-lending outfits like to crow about saving borrowers money, lenders through those sites can command interest rates up to 30%, better than even some of the steepest credit cards.

With reward comes risk, of course: Late payments and defaults on loans facilitated by social lenders have crept up recently due to the economic climate. At Prosper.com, the oldest social-lending site, launched in 2005, nearly 17% of all the loans since inception have been charged off--meaning that Prosper had not received a payment in more than four months and has since written down the value of those loans to zero on its books.

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Social-lending sites come in different flavors. Some, like GreenNote, aimed at the student-loan crowd, connect lenders and borrowers directly. At GreenNote, students roust backers by posting engaging profiles to its site; interested beneficiaries lend a hand by lending $1,000 to $50,000 at a fixed 6.8% interest rate, in line with the federal Stafford loan program. The funds flow straight to the school--not into students' late-night Domino's pizza fund. Students must pay down their debt within six months of leaving school and must pay the aggregate amount within a decade. GreenNote collects 2% of the loan amount off the bat when the deal is struck and also charges 1% of the outstanding loan amount every month as a servicing fee.

Other social lenders run online auctions, a la EBay (nasdaq: EBAY - news - people ). One of these, called Lending Club, matches borrowers and lenders based on loan size, risk tolerance and social familiarity (think co-workers, fellow alumni and hometown residents).

In an auction model, borrowers don't borrow directly from lenders. Instead, they receive loans from a third party--in this case, a bank--with which Lending Club has contracted. Lenders purchase promissory notes, backed by the interest on the loans, from Lending Club. (The site also runs a secondary market online where investors can trade those notes.) As for default rates, 2.4% of borrowers have fallen 31 to 120 days behind in their payments, while 3.6% are more than 120 days behind.
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"The problem with this industry is that the borrowers most desperate for loans who turn to these companies are often the ones who are likely to [default]," says Bruene. "The upside is that it's pretty powerful to be able to go to a Web site and tell your story to thousands of potential lenders rather than a handful of banks. If the industry can properly manage the risk involved, there's a lot of potential for success."

The growth of auction sites--and their potential risks to lenders--has since caught the glare of the U.S. Securities and Exchange Commission. While there's no law against borrowing money from friends, family members or even strangers, the SEC had a bone to pick with lenders generating a return on those security-like notes.

When the agency came after Prosper.com, the largest auction-style player, last year, Chief Executive Chris Larsen pushed back, arguing that given the site's transparency, lenders knew full well the risks they were taking. Still, in November, the SEC served Prosper with a cease and desist order, asserting that it violated the Securities Act of 1933 by selling as much as $174 million in unregistered securities. Days later, a group of 20 states filed a class action lawsuit against Prosper for selling unregistered securities. The company has since paid $1 million to settle that suit and is now in a quiet period while it registers as a broker of securities.

GlobeFunder Ventures is yet another breed of social lender, one that acts as a liaison between borrowers and traditional lenders like banks and hedge funds. Say you want to buy a deep fryer for your restaurant. The equipment retailer plugs your information into GlobeFunder's online system; if your profile matches a willing lender's specs, you get the loan right there on the spot, forgoing a trip to the bank. Each lending institution sets different minimum FICO scores and debt-to-income ratios.

Borrowers pay only the stated interest rate, 7% to 20%, while GlobeFunder takes an undisclosed cut of the sale from the retailer. If Globefunder services the loan, it charges the lender 1% to 2.5% of the loan amount; if the lender services it, Globefunder charges a one-time (again, undisclosed) brokerage fee.

Social lending alone can't thaw out the credit markets, but every little bit helps. "Now, even those with excellent credit are having trouble getting traditional loans," says James Van Dyke, founder of Javelin Strategy & Research, a Pleasanton, Calif.-based financial services consultancy, who has high hopes for social lending. "With new regulatory clarity, we should see a pop soon."

That would be nice.
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