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PAGE ONE Economics


Peer-to-Peer Lending
Katherine Ren, Economic Education Intern

Annual percentage rate (APR): The percentage cost of credit on an annual basis
and the total cost of credit to the consumer. APR combines the interest paid
over the life of the loan and all fees that
are paid up front.
Credit report: A loan and bill payment history kept by a credit bureau and used by
financial institutions and other potential
creditors to determine the likelihood that
a future debt will be repaid.
Credit reporting bureau: An organization
that compiles credit information on individuals and businesses and makes it available to businesses for a fee.
Credit score: A number based on information in a credit report, which indicates a
person’s credit risk.
Interest rate: The percentage of the amount
of a loan that is charged for a loan. Also,
the percentage paid on a savings account.
Liability: money owed; debt.
Microloan: A small, short-term loan at low
interest, often used by self-employed
individuals or entrepreneurs for start-up
expenses, inventory, or equipment.
Soft inquiry: Any check of a person’s credit
report that occurs when the person’s
credit is not being reviewed by a prospective lender. Examples include inquiries as
part of a background check, a person
checking his or her own score, and checks
by a financial institution with which a
person already does business.

“Some debts are fun when you are acquiring them,
but none are fun when you set about retiring them.”

—Ogden Nash, American poet

If you have ever taken a personal finance class, you likely remember that
the teacher emphasized the importance of maintaining a good credit
score. The teacher might have said that a good credit score gives you
access to loans and credit cards with comparatively lower interest rates.
In addition, you were likely warned of the consequences of a bad credit
score and the potential dangers of easy-access payday loans that offer
cash at an annual percentage rate (APR) as high as 400 percent.1
As the terms “FICO® score,” “interest rate,” and “loans” were thrown around
in class, perhaps it wasn’t long until you found yourself wondering about
your own credit score and its implications. So, what does a Fair Isaac
Corporation (FICO) score tell lenders? What’s a good credit score, and
how does it affect the interest rate you’ll pay? How is traditional lending
different from other types of lending? And if payday loans are risky, are
there other alternatives to traditional lending?

Traditional Lending and Credit Scores
When creditors consider making a loan, they look at the borrower’s credit
score to assess that person’s ability and willingness to make payments on
time. While an individual’s credit score is not the sole factor affecting a
credit application, the credit score influences not only the amount a lender
will provide but also the terms of the loan such as the interest rate. One
of the most common scoring techniques used by 90 percent of top lenders
is the FICO score. A base FICO score ranging from 300 to 850 is generated
by considering a combination of an individual’s information (see the boxed
insert). As with most scoring methods, a higher score is better; the premise
is that the higher the score, the less risk posed to lenders.2
In addition to reviewing the FICO score, the lender also carefully reviews
the borrower’s credit report, a summary of the individual’s payment history. The three major credit reporting bureaus—Experian, TransUnion,

November 2015

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PAGE ONE Economics®

Determining a Credit Score
What type of information is used to determine your credit score?
FICO uses the following information to generate credit scores:


Payment history
Length of payment history
Types of credit in use
New credit accounts
Current liabilities

Scores range from 300 to 850. In general, FICO credit levels fall into
the following categories:1


300-550: Poor credit
550-620: Subprime
620-680: Acceptable credit
680-740: Good credit
740-850: Excellent credit


Category ranges vary by creditor. If you apply for a loan, a loan officer
from one institution may consider a FICO score of 680 to be in the “good”
range, while a loan officer from another institution may consider it only
“average.” The ranges shown above are from See Lamb, Lori.
“What Is a Good Credit Score?” Personal Finance News and Advice (blog),
January 22, 2014;

and Equifax—collect information from banks, credit
card companies, finance companies, and other lenders
to generate credit reports. In fact, the FICO score and
the credit report go hand in hand in determining the
creditworthiness of a loan applicant.

Peer-to-Peer Lending: An Alternative
Peer-to-peer lending is a relatively new method for
obtaining credit. Similar to microloans and crowdfunding resources, peer-to-peer lending started as an avenue
for impoverished borrowers to access loans without
collateral. Sites such as Kiva connected donors of the
developed world to entrepreneurs in the developing
world. However, the concept has since evolved to serve
as a credit opportunity for individuals in the developed
world as well. Sites such as Lending Club and Prosper
connect individual investors to borrowers who may not
be able to obtain loans through traditional avenues.
These sites provide mainly debt consolidation loans,
credit card payoff loans, and small business loans.3 How-

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ever, borrowers are not limited to these uses and may
apply for loans to cover a wide range of needs such as
car loans.
Aside from providing high-risk borrowers with potential
credit, a couple of key characteristics differentiate peerto-peer lending from traditional lending. Perhaps the
greatest difference is that peer-to-peer lending sites offer
loans that are directly backed by investors as opposed
to financial institutions. The majority of peer-to-peer loans
are funded by many investors—not just one investor.
Depending on the borrower’s payment history, loans can
be received in as little as one business day and usually
have a payoff expectation of about 36 months. In addition to providing a FICO score, borrowers have the option
to share private information in their profiles and are able
to receive “endorsements” from other users to increase
their credibility as a borrower. As with traditional lending
methods, an individual’s FICO score and debt rating factor into determining the interest rate of a peer-to-peer
loan request. Borrowers are not required to submit collateral and thus the loans are unsecured. In addition,
the sites charge borrowers in the form of origination or
closing fees that range from 0.5 to 5 percent of the value
of the loan.4
The average peer-to-peer borrower has a FICO score of
about 700 and is granted a loan with an interest rate
ranging from 8.67 to 13.5 percent. However, some
investors are willing to accept riskier borrowers with
credit scores close to the minimum of 630 and offer to
fund loans at APRs of more than 30 percent. Thus, peerto-peer sites can serve as credit opportunities for those
who are turned down by traditional lending institutions.
Likewise, peer-to-peer loans are an alternative to payday
loans that on average leave a borrower indebted for
about 6 months with annual interest rates over 400 percent. Furthermore, while borrowers can receive loans
ranging from $1,000 to $35,000, it is important that they
do not borrow more than necessary because they will be
faced with not only higher interest rates but also higher
origination or closing fees. Finally, it is wise for borrowers
to apply to more than one peer-to-peer lender to compare the different rates offered. Unlike traditional loan
applications, a peer-to-peer application does not negatively impact the borrower’s credit score because it is
classified as a soft inquiry.5

PAGE ONE Economics®
Peer-to-peer lending is a high-risk, high-return option
for investors. While the yields tend to be higher than
similar investment options, such as certificates of deposit,
the loans are unsecured with no guarantee of repayment from either the borrower or a third-party governmental agency. However, there are still strategic ways
for investors to choose lending options, such as diversifying their loan choices and watching trends. As with
stocks, the best way for an investor to hedge risk is to
invest in a range of borrowers. Instead of fulfilling one
borrower’s entire loan, it is wiser to partially fund a variety of loans from multiple borrowers of different risk
levels. Similarly, it is often beneficial to gauge the credibility of a borrower by watching the investments of other
investors. For example, if two borrowers of very different
risk levels receive the same amount of money, it is likely
that an investor studied the higher-risk borrower and
determined that (despite the high risk) the borrower is
in fact creditworthy. As a result, other lenders might consider this an indication of a good investment choice and
add to the funding of the loan request. This phenomenon
is known as herding and refers to how investors often
look to their peers to gain more information on the
investment—in this case, more information on the borrower than a simple FICO score or other rating may reveal.

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Encouraged by the demands of consumer culture, peerto-peer lending has evolved tremendously over the past
decade. Borrower requirements are more accommodating than they are for traditional lending, and interest
rates are lower than they are for payday lending. Sites
such as Lending Club and Prosper offer loan alternatives
for borrowers and investment opportunities for lenders.
What started out as a modest effort to allow more lowincome and credit-risky borrowers to obtain loans has
become a revolutionary tool connecting borrowers to
investors. n

1 See

Center for Responsible Lending. “Payday Loans.”
2 See Fair Isaac Corporation. “What Is a FICO Score?; and Kapoor, Jack R. “Consumer Credit,” in Jack R. Kapoor, Les
R. Dlabay, and Robert J. Hughes. Glencoe Business and Personal Finance.
Columbus, OH: McGraw-Hill Education, 2012, pp. 451-514.

Zhang, JuanJuan. “The Wisdom of Crowdfunding.” Federal Reserve Bank of
Boston Communities & Banking, Winter 2013, 24(1), pp. 30-31;; and Hayes, Adam. “What Is Microlending and How Does It Work?”
Investopedia, April 7, 2015;

Horymski, Chris. “What You Need to Know About Lending Club and
Prosper.” Consumer Reports, January 5, 2015;

Jones, Sally. “Peer to Peer Lending Site: Lending Club vs Prosper vs Upstart.”, March 20, 2015;

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