Peer-to-Peer Lending Is Poised to Grow
Yuliya Demyanyk and Daniel Kolliner
Peer-to-peer lending—a type of lending which matches individual borrowers with investors—is a recent innovation. But because it fills at least two gaps left by traditional lending sources, the peer-to-peer-lending market is likely to continue growing for some time.
Emerging first in the United Kingdom in 2005 and arriving in the United States a year later, the peer-to-peer market has been growing rapidly since its inception, while traditional consumer bank loans and credit-card lending have been declining. Since the second quarter of 2007, the total amount of money lent through bank-originated consumer-finance loans has been declining on average 2 percent per quarter and the total amount lent through bank-originated credit cards has been declining on average 0.7 percent per quarter. Meanwhile peer-to-peer lending has been growing rapidly at an average pace of 84 percent a quarter.
Peer-to-peer’s rapid growth may be attributable to two of the benefits it provides. First, it can improve access to credit for individuals who have short credit histories. Second, it allows consumers to consolidate credit card debt and lower their interest rate more than they could by going through traditional lenders.
Peer-to-peer lenders use income, the type of employment, and even SAT scores in addition to credit scores and histories to assess the creditworthiness of borrowers. As a result, peer-to-peer lending could improve access to credit for consumers who, for example, are denied a loan by a bank because their credit histories are short, even if their credit scores are sufficiently high. A significant number of people fall into this category. According to data from Equifax, one of the three largest US credit bureaus, 39.8 percent of people with credit histories shorter than three years have credit scores higher than the subprime threshold, in other words, generally good enough to obtain a loan (Equifax, Federal Reserve Bank of New York’s Consumer Credit Panel).
Most peer-to-peer loans are used to consolidate high-interest-rate credit card debt. Data provided by Lending Club, a company that arranges peer-to-peer loans, shows that 83.3 percent of peer-to-peer loans are personal one-time loans, most of which are put to use for this purpose. This may be explained by the fact that interest rates on peer-to-peer loans have been lower than those on credit cards since 2010:Q1.
Not every peer-to-peer borrower manages to obtain a better interest rate than a credit card rate. Peer-to-peer loans are categorized by grades A to D, reflecting the probability of default. On average, around 50 percent of loans are awarded a grade of “A” or “B.” These consumers are considered the least risky borrowers, while borrowers with grades “C” or “D” tend to be riskier. Borrowers with loans graded “A” or “B” have consistently been getting better rates through peer-to-peer lending compared to credit cards. For borrowers with good scores, interest rates have a strong negative correlation with the credit card interest rates, meaning that when banks increase their interest rates, peer-to-peer lenders decrease theirs.
In comparison to bank-originated consumer-finance loans, peer-to-peer loans performed either similarly or slightly better. On average, between 2010:Q2 and 2014:Q1, 3.2 percent of peer-to-peer loans were past due compared to 3.7 percent of standard consumer finance loans. Over this period, peer-to-peer loans had a lower share of poorly performing loans in 10 of 16 quarters.
The peer-to-peer market is currently hundreds of times smaller than the consumer finance and credit card markets. However, the data suggest that the peer-to-peer lending market will continue to grow. One reason is that the supply of funds from investors for such lending has been increasing. Though peer-to-peer lending started as individual investors lending to individual borrowers, institutional investors, such as community banks, have become involved over time. Another reason that peer-to-peer lending is poised to grow further is that demand for such loans has been increasing. Individuals who either cannot get loans from traditional banks or who wish to consolidate their credit card balances at lower interest rates find peer-to-peer lending an attractive alternative.