Quintessential Considerations — Marketplace Lending

Inclusive Marketplace [GIPHY]

What is Marketplace Lending?

Marketplace Lending or Peer-to-Peer (P2P) Lending is a community connecting those who need loans to those who can fund loans, where money flows from those who have excess cash to those who need some excess cash.

  1. Think of the last marketplace you visited that connects buyers to sellers. This could be a lively fish market, a flea market with great deals, or a farmer’s market with those local, organic jams you almost never finish. Now imagine a market where the ‘buyers’ are individuals who have some cash lying around that they want to put to use and the ‘sellers’ are actually borrowers looking for money for a large personal expense. This is Marketplace Lending where the product is a loan! Marketplace Lenders simply facilitate this transaction space where ‘sellers’ can get upfront money from the ‘buyers’ as a loan, with a promise to pay it back over a relatively short time period.
  2. Why would a borrower look for money here? Banks require financial proof that confirms a borrower will pay the loan back. Unfortunately, this means owning a car, a house, having multiple lines of credit, and having a stellar payment history (factors that contribute to the holy FICO score). I argue that this perspective unfairly discriminates against students and those who may be living paycheck to paycheck, and also those who may have recently immigrated into the country. As managers of this marketplace, Marketplace Lenders employ a broader lens to evaluate creditworthiness of borrowers, utilizing future employment prospects, purpose of loans and social/behavioral cues, along with traditional financial metrics.
  3. Also, banks tend to move slow. The typical approval process for a traditional bank loan can take a few weeks with an in-person component, while newer P2P Lenders leverage technology to process applications in a few minutes. With an online KYC workflow and less operational overhead, Marketplace Lenders are able to provide quasi-banking services at a fraction of the price. These companies also claim to add value to both the borrowers and the lenders through features that offer financial literacy, for example, access to content about savings and functionality that allows for budgeting. Some lenders also help with credit building for the thin file through curated financial plans and credit-building loans.
  4. At the inception of the industry in the early 2000s, P2P Lending proved to be a working business model. The marketplace thrived as it addressed a true demand for easier access to credit, and also created an entirely new asset class for those looking to generate returns on their disposable income. However, operationally, it is more efficient to connect multiple borrowers to single entities like hedge funds, asset managers or banks (read: $$$). Most Marketplace Lenders have iterated on a model where an institutional investor funds the loans of multiple borrowers at the same time.
  5. Now, Marketplace Lenders are NOT banks (although some may procure a banking charter). They are not subject to the same stringent regulations as banks are. As such, they walk the fine line between generously helping out borrowers and offering payday-esque loans with an extremely high interest rate, up to 36% in some states (subject to local usury laws). To this end, before you engage with such lenders, make sure you are aware of the mechanics of the interest rate, the fee structure (delinquency fees and prepayment fees are good ones to check) and if refinancing, understand the implications of possibly waiving federal benefits. Financing a loan in this space can seem tempting because these companies offer appealing terms and are often not secured by any assets, but it is important to note that the payment history is reported to all major credit bureaus and can result in a stain on your long-term credit.

6 Through Infinity: FICO Score, Alternate Score (CredoLab), Regulations for MPL, Credit Builder Loan, MPL in the UK, KYC

The Quintessential Considerations series attempts to simplify the world of Finance, by highlighting the top 5 ideas you need to know about each concept. To dig in further, scroll to the bottom and navigate the links within “6 Through Infinity”. Check out my posts on Warehouse Lines of Credit here and Discounted Cash Flow Models here.