How to bypass the bank and get a loan

Websites are allowing person-to-person loans, cutting out the middleman.

A man dressed as the animated movie hero Mr. Incredible presents himself before a group of lenders. He wants a new gaming system, new wakeboard bindings, and maybe a vacation. Or, as he puts it, "$6,000 to blow for fun." And he's willing to pay 10 percent annual interest for a three-year loan.

Conservative financial institutions might have found his outfit off-putting, but members of the social lending website Prosper seemed to appreciate the borrower's photograph and AA credit rating posted on the site. Over the course of a week, 180 lenders offer to buy small chunks of the loan, bidding the interest rate down to 8.99 percent. By the time the online auction ended, almost 90 lenders had divvied up the loan.

"I think a bit of emotion kicked in with Mr. Incredible. [He was] kind of like an alter ego," says Mike Beer, an airline pilot who lent $50 toward the $6,000 loan. "It was like, 'you go,' because I could never borrow money to buy toys. Not my thing."

Prosper, open to the general public since February 2006, is the United States' first – and only – online marketplace where anyone with $50 can receive interest on money they lend. Although the market is small – the website only recently surpassed $56 million in loans – opportunities for people interested in investing in personal debt are growing. Over the past six months, the amount of money Prosper members lent out almost doubled from the previous six months.

Social lending removes the middleman, allowing both lenders and borrowers to get better rates, contends Chris Larsen, CEO and cofounder of San Francisco-based Prosper. "A bank is coming to you and saying, 'I'll take your money – it's worth 4 percent' and literally lending it out at 19 percent," he says. Instead, he suggests that maybe you and your neighbor could come to an agreement on a loan at 12 percent.

Prosper makes its money by charging its members fees on loans, which range from 0.5 to 1 percent for lenders and 1 to 2 percent for borrowers, depending on the credit grade of the borrower. Mr. Larsen estimates that borrowers can get rates 3 to 5 percent lower on Prosper than they would with a credit card.

The estimated average annual return on loans to borrowers with AA to D credit scores ranges from about 6.0 to 8.5 percent, according to the company. Returns for loans to borrowers with E and HR (high-risk) rated credit scores are negative, though Prosper has recently strengthened its requirements, mandating that borrowers have a credit score of at least 520 to be eligible to apply for a loan.

Some lenders use other criteria to improve their rates of return. Kurt Dickey, a North Carolina technology product specialist has lent almost $40,000 on over more than 240 loans. He has a standing that allows him to automatically bid on loans when preset criteria – including credit grade, home-ownership status, repayment method, past defaults, membership in community groups, debt-to-income ratio, and interest rates – are met.

"I tweak it," says Mr. Dickey. "When I do have time and I have money, I go on there and troll around and find loans that I have an interest in."

Dickey's investing efforts are paying off. He says that according to his lender's statements, his rate of return is 13.6 percent.

But the returns are not risk-free, says Russell Wild, an Allentown, Pa., financial planner and author of "Bond Investing for Dummies" due out in September. The risks that lenders face include defaults and the potential for fraud, Mr. Wild says. He also notes that the rate of return is inflated, since it doesn't take into account the time money spends sitting idle in a Prosper cash account not making any return at all.

Indeed, Dickey notes that his recent $10,000 deposit took two weeks to make its way into the loan market.

In addition, once a loan is made, it can't be resold, so lenders' money is tied up for the three-year life of the loan, says Wild. He views Prosper investments as comparable to junk bonds and is waiting to see if the returns are higher than such high-risk bonds before recommending the site to his clients.

Larsen says that Prosper recently introduced a scheduled transfer feature, so that lenders could transfer smaller amounts of money, limiting the amount of time it sits in a cash account without collecting interest. The company is also looking into creating a secondary market for loans, he says, though regulatory hurdles are daunting.

Prosper will soon face new competition: Zopa, a person-to-person lending website that has been running in Britain since 2005, intends to open in the US market later this year. Prosper's future rival may spur improvements in the social lending industry, says Zopa's CEO Doug Dolton.

"The US market is huge; it's actually better if you have more competitors," says Mr. Dolton, since you have someone to be measured against.

Larson agrees. More competitors validates the industry, he says. But he's quick to point out that, while Zopa has released few details about how its US operations will look, in Britain, lenders aren't able to bid on specific borrowers. Instead, British lenders only choose the credit scores and length of loans. Choosing specific borrowers is a draw for Prosper lenders, many of whom see their loans not just as investments, but also as a way to lend a helping hand to those in need of short-term cash.

"It's kind of nice when there's somebody that you're helping out, and you get an e-mail from them and they're thanking you," says Vince Polizatto, a credit officer who works in Washington, D.C. "Having said that, I [made] two loans that are in collection."

Loans that are more than four months late are sold to debt buyers, and there is no mechanism for debt forgiveness. Larson adds that Prosper is not for those interested in charity.

For those who are, San Francisco-based Kiva Micro­funds joins with microfinance groups in developing countries to allow individuals to give small, interest-free loans to entrepreneurs. Since its inception in 2005, no borrower has defaulted, but if someone is unable to repay his or her loan, the complete cost of it is borne by the lenders, says Fiona Ramsey, Kiva's community and operations manager. "We don't want to create an additional burden of debt on the borrowers."

Those who are earning an 8.99 percent return lending to "Mr. Incredible" – aka Texas programmer Kevin Conner – may not get a charitable feeling from their loan, but they won't miss out on the human touch. Mr. Conner says he'll try to tell his lenders later this summer which games he buys – he's already bought a 42-inch TV monitor, he writes in an e-mail – and where he goes on vacation. "It would be good to keep those that are interested informed."

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How to improve credit

To determine the credit worthiness of potential borrowers, the social lending website Prosper relies on a scoring system provided by Experian, a major credit reporting agency in Costa Mesa, Calif. Experian's credit scores are used to "grade" borrowers from AA (topgrade) to HR (high risk) and help lenders assess whether it's worth loaning them money. (You can obtain your credit report – one free report per year – at

Prosper grade: Experian score

AA: 760 and above
A: 720-759
B: 680-719
C: 640-679
D: 600-639
E: 560-599
HR: 520-559

To improve your credit score, pay bills before they're more than 30 days overdue, avoid extra credit-card applications, and keep credit-card debt under 40 percent of available credit, says Gary Thurberg, at Consumer Credit Counseling Services of Central New York. Establishing a credit history (which includes secured debt such as a mortgage or auto loan, and unsecured debt such as a credit card), matters, too: You may pay your utility bills, cellphone, and rent on time, but typically payments aren't reported to a credit agency unless the bills are sent to collection, he says.

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