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Crowdsourcing Your Finances Through Social Lending

By Edited Nov 13, 2013 0 0

Social Lending

Money is tight these days and when you have an endless pile of bills to pay things can get stressful. But getting loans is as difficult as ever, if not more difficult, especially for students who may not have an established credit score. So what do you do? What about asking your friend for a loan? Or your relatives? What about a total stranger? This article discusses the concept of social lending and some of companies involved in it, concluding with some speculation as to what this may mean for the financial system as a whole.

Zopa, or "Zone of Possible Agreement," is a UK-based company founded in 2005 that provides an online service which allows people to make monetary exchanges with anyone in the network, regardless of their relationship to that person. Zone of possible agreement is a negotiating term which defines the boundaries within which an agreement can be reached between two parties. In the case of this company, it defines the boundaries of how users may exchange funds for the mutual benefit of both parties. A person interested in getting a loan simply can logon to the site, enter the amount they wish to borrow and the number of months over which they want to repay the loan. Alternatively, someone who has extra money and wants to find the best interest rates can earn money by lending out their money to other people. This is more beneficial to the lender than putting their money into a traditional bank or credit union because the interest rates are determinable by the user and thus can be much higher and therefore more profitable. Keep reading to find out how it works.

For Borrowers:
A borrower interested in getting a loan need only logon to the site and use the loan calculator to see what rates are available to them. From there, they can apply for a loan by submitting their information and receiving a credit score from Zopa. The general criteria for borrowers is that they  have a confirmable identity, a visible credit history, an income that fits their loan repayments, and a sound repayment history. If the borrower is approved, they will be placed into one of several sub-groups broken down by credit score/history, socio-economic status, age, and the length of their repayment plan. The borrower then can pick a loan and reserve it while the company concludes its risk assessment and background check.

So why would a borrower choose Zopa instead of a traditional institution? The APR
Zopa
(annual percentage rate) for loans is set much lower than the rates set by conventional lenders. According to loan comparison websites, the typical 3 year loan for £5,000 is between 8.0% and 12.9%. Zopa, in contrast, offers rates of only 7.3%, which shows it is indeed the best choice for those looking for a low APR. Also, the borrower can choose a loan in a wide range of sizes; anywhere from £10 to upwards of £25,000.

For Lenders:
Zopa has its own markets that are segmented into borrower groups (A*, A, B, C, or Young) based on their credit score/history, socio-economic status, age, and how long they want to borrow (36 or 60 months). Here is a chart graphing the exchange rates that their users have earned with between 2010 and 2011:
Zopa Interest Rates

Keep in mind that these are rates from the United Kingdom and not the United States. To put this in perspective, the current UK base interest rate as determined by the Bank of England is only 0.5%, so the interest rates of Zopa are as much as 19 times greater than the base rate. When compared to current US base interest rate (prime interest rate), which is 3.5%, Zopa's business model could hypothetically allow for interest rates of up to 10%-15% (a conservative estimation). Lenders can choose how much to lend, the interest rate (based on which group they lend to), and how they will receive their payments (monthly, annually, etc.).

This may sound too good to be true, how do lenders know they will be repaid? Well Zopa has a plethora of protective measures to ensure that lenders receive their money on time and in the correct amount. As mentioned before, Zopa assesses the credit score of all potential borrowers before they are put into the system. This includes identity checks, credit checks, and risk assessments. In addition, the company provides predictive models for the amount of bad debt they experience in a given market (of borrowers); diversifies risk by dividing loaned funds across multiple borrowers (diversification is directly proportional to the amount of money being loaned); a collection agency to chase missed payments in the same way as traditional financial institutions; and legal protection in case Zopa were to ever go out of business.

So at this point you might be asking why isn't it in the US? The answer, unfortunately, is that Zopa doesn't want to be. In late 2007, Zopa began working with several American credit unions but the partnerships ended in the following year when the subprime mortgage crisis caused the company concern over the potential for bad debt rates of new borrowers.

Prosper Marketplace
Despite this, the idea of online social lending (or peer-to-peer lending) has taken off fantastically since the formation of Zopa. A similar US-based company known as Prosper Marketplace, was founded in 2006 by Chris Larsen, co-founded of E-LOAN, and has since been relaunched with full SEC registration in 2009. Prosper operates similarly to Zopa but with a slightly different criteria for assessing their borrowers (they are known as investors). The rates are highly competitive (10.69% annual returns compared to the national rate of 3.5%) although borrowers have APRs more equivalent to those of other financial institutions (fixed rates between 6.59% - 35.84%). Currently Prosper is available to residents of 28 different US states and the District of Columbia.

The takeaway from all this is that the financial world is changing. The need or want for banks may be diminishing as a consequence of the problems that arose as a response to the economic recession. As the social structure of our country (and by extension the economy) becomes more digitalized, there may come a time when all traditional functions of banks may be done over the internet. If social lending can be utilized on a larger scale, it may be a great alternative to the current structure of financial institutions.
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