We often assume a P2P (peer to peer) loan is used for business. A farmer needs to buy livestock feed. A textile mill needs cloth and new machines. A retailer needs inventory. These are all excellent use cases for funding through a platform such as Colendi.
But not all loans have to be about commerce. Sometimes people borrow money because they genuinely need to spend it on themselves or their families, as Financial Samurai reports. Paying medical bills are at the top of that list. Home and auto loans are ubiquitous in much of the world, as are education loans. Also, a lot more families than you might realize have taken out loans to cover the cost of adopting a child. And some households even need to borrow to pay their taxes. However difficult it might be to pay off a high-interest loan, that option has got to be more palatable than going to prison.
Ultimately, the most frequently cited reason for borrowing P2P is the one that commands the least attention: debt consolidation. More often than not, borrowers already have credit, but it’s at a higher rate than they can afford or conscience can justify. Pawn shops will lend you money at high interest providing you have collateral you’re willing to leave with them. And if you miss a payment, your collateral is forfeited and resold. Credit cards might be easy to obtain for many people throughout the world, but their convenience can lead to a spending trap. Even if you have the willpower to avoid impulse purchases, you still most likely have to pay interest rates double or triple what you would incur through a bank loan. Payday lenders will also be happy to help you out of a cash crunch if you have exceeded your credit card limit but be prepared to pay an even higher rate.
The true bottom feeders, though, are the so-called “business loan specialists”. There happens to be a time-honored tradition of working-capital loans that help enterprises smooth things over when their inventory is on the move. This is usually very short-term – typically the month or so it takes for the goods to leave the warehouse, get loaded onto ships, find their way to their destination and be paid for by an importer. Because the term of the loan is so short, a lender needs to charge a lot in order to make any money on the deal. Working-capital loans could run to 400% or higher on annual basis, but the whole concept is to pay it back in a matter of days or weeks. But today’s “business loan specialists” are taking this model and essentially turning it into permanent debt. They take advantage of people who need money for expansion or other purposes and will take years to pay back.
But let’s call it quits here. We could keep going and talk about loan sharks, but there’s no need to go to illegal sources of capital when the world is full of many disreputable ones. And of course, you can always borrow from family or friends, but you’ll end up owing more than money.
Getting credit for creditworthiness
That’s where P2P comes in. In this new marketplace for lending and borrowing, there is no legacy financial institution that needs to be paid an exorbitant amount to do little more than serve as a clearinghouse. Money that would otherwise go toward maintenance of high-rent brick-and-mortar property and an overpaid retinue of bank vice presidents can stay in the counterparties’ pockets. And because we’re not playing with the banks’ money, we don’t have to play by the banks’ rules when it comes to determining who should be entrusted with capital.
As we previously reported here on the Colendi blog, the FICO scoring algorithm—which guides most commercial lenders’ credit decisions—is not aging well. To restate:
“FICO does have the advantage of simple elegance: it’s mostly a factor of a consumer’s payment history and amount owed. And as long as you have a long history of paying all your bills on time, you’ll score high. Where it all falls down, though, is that it looks backward, not forward. Credit history is one way of predicting whether or not a debtor will pay back a specific creditor in full and on time, but not the only way. It might not even be the most reliable way.”
Our response is to rely only partially on a borrower’s financial history. At Colendi, we also look at mobile phone behavior, utility payments, online spending habits and social media followers to determine how the rest of the world sees you. See our white paper for more detail.
Of course, people who make a living in financial services are far from stupid. They understand that P2P lending is a threat to the established order. Many have concluded that old-school bank loans belong to another era, but that doesn’t mean they can’t figure out a way to benefit themselves in this new environment. That’s why picking your platform is so critically important, especially for borrowers.
Not all lenders are truly your “peers”. A lot of them are institutional investors or hedge fund management companies. While this has the positive effect of making more funds available for loans, it also has the negative effect of raising interest rates to roughly where they would be if you asked for money from a bank. The people here at Colendi urge you to know your lender. Make sure they’re a counterpart you can trust, not a bank hiding behind the avatar of a human being.