Suze Orman Money Matters

Consumers unable to qualify for a traditional loan, or unwilling to put up with the red tape and high costs, are increasingly turning to peer-to-peer lending sites such as Prosper, LendingClub, Zopa, and Virgin Money. Think eBay for personal loans: Instead of matching individual buyers and sellers of goods, these sites bring together potential borrowers and lenders.

I'm all for social networking, but p2p lending is full of risks I don't think many borrowers or lenders fully appreciate, or are paying attention to.

Easy ≠ Smart

The fact that money may be just a few clicks away is indeed tempting. But that doesn't automatically make it a wise move for either the borrower or the lender.

Let's take a look at one of the recent listings that sent my blood pressure up. A gentleman was looking to raise $10,000 for a home down payment via Prosper. The website determined his loan rate after checking his credit file. After a quick crunch of the numbers, Prosper determined he was a lousy credit risk and slapped a 35 percent interest rate on his loan.

No, that's not a typo.

I suppose I shouldn't be surprised that someone with a ridiculous credit profile would have no compunction about trying to borrow money at such a high interest rate. But here's where it gets really insane: Last time I checked, this guy was more than halfway to raising the money he needed. Yep, lenders were ponying up the money for his loan, no doubt enticed by the prospect of earning a 35 percent return on their money.

Think Before You Borrow

Somehow I doubt they took the time to check out Prosper's laudable reporting of the default rate on its loans. If they had, they would've noticed that the higher-risk borrowers have a reported default rate of more than 18 percent. In traditional lending, if you had default rates half that high you'd be out of business.

Then there was the borrower at LendingClub looking to raise a few thousand dollars to pay for a wedding. Her interest rate: 11.25 percent. That might seem reasonable when compared to 35 percent, but it's still a steep price to pay. Moreover, the person was looking to borrow money for an expense that I think should be avoided, not financed.

That's one of my big concerns with these websites: Borrowers can take out loans for just about any project or expenditure. But easy money isn't the same as smart money. Before you sign up to borrow from one of these sites, first ask yourself if you really and truly need to borrow the money, or if it's just money you want to borrow.

Borrower Tips

That's not to say I'm totally against borrowing from these sites. In fact, a good number of people seem to be using the p2p model to intelligently deal with high-rate credit card debt. I saw plenty of borrowers looking for a loan at 10-15 percent or so that they would use to pay off a credit card balance that was more than 20 percent. That can make a good deal of financial sense.

As with all financial deals, though, you need to understand the rules of the road:

• It's all about your FICO score

If you have a score of at least 640 you can qualify for a loan, but it's going to have an astronomical rate. My general advice is that any loan to purchase something or finance a business endeavor that costs you more than 10 percent should be a big warning signal.

Again, don't be blinded by the ease of accessing the money. What you really need to carefully consider is your ability to repay that loan. The one exception to this is if you're looking to use the site to pay off credit card debt; if you can pay off a card that's costing you 25 percent with a p2p loan that runs you 15 percent, that's worth considering. But before you do that, keep reading.

• Borrowing to pay off credit cards won't improve your FICO score

Money you borrow through a p2p site is reported to the credit bureaus as a personal loan. Even if you pay off $15,000 in credit card debt, your credit report will now have a new $15,000 personal loan debt. Thus you haven't gained any ground in reducing your overall debt -- you've simply lowered the interest rate you must pay on the debt.

That's still a solid move in that it should enable you to pay off the debt faster. But don't expect any instant FICO miracles the minute you pay off the credit card balance.

• Fees vary from site to site

At Propser, your annual fee is determined by your credit score, and can range from 1 to 3 percent. Virgin Money doesn't play matchmaker for borrowers and lenders. Instead, it serves as the official middleman for borrowers who already have lenders lined up and both parties want to create a formal agreement.

Virgin has a full lineup of loan servicing agreements for personal and business loans. The cheapest is a $99 Handshake Basic agreement for personal loans between friends and family.

Hiring Virgin Money to draw up the promissory note and a repayment schedule might indeed be worth that money to you. Or you can download a promissory note document form from Nolo for less than $10.

Lender Advice

I totally get the allure here. Your money in the bank is earning 3 percent at the same time inflation is above 4 percent. So the opportunity to lend that money and land a 10 percent, 15 percent, or 35 percent return seems to make a lot more sense. But you need to think about risk:

• It's an unsecured personal loan

If the borrower fails to repay, you're out the money -- you have no recourse. And while the p2p sites are quick to recommend that lenders build a diversified portfolio of loans by making a series of small loans to multiple borrowers rather than risk one big loan to one borrower, if you lend to 20 high-risk borrowers you still have a high-risk portfolio.

One exception to this model is Zopa. Zopa lenders invest in a federally insured 1-year CD that pays a competitive rate -- about 3.7 percent recently. The lender then chooses a Zopa borrower (rates paid by Zopa borrowers vary from 8.5 percent to 16 percent) she wants to help and agrees to use a portion of her investment -- it can be as little as $20 -- to help pay down the borrower's balance.

From the borrower's perspective, the more people they get to help, the lower the total borrowing costs. From the lender's perspective, they may earn more than they could get on a standard bank CD, but at under 4 percent recently, the payoff is more psychic than real profit.

• Look for quality

If you want to lend money, stick with borrowers that have a solid credit rating. Even then, be prepared for a net return that might be a lot lower than the rate you initially see.

For example, using two years of data, Prosper reports an average lender rate for high-quality borrowers of 10.97 percent. But once you factor in the default rate and fees on those loans, the estimated net return for the lender clocks in at 6.85 percent. And those are the average returns for high-quality loans; the numbers begin to look downright ugly as you move down the credit ladder.

• Factor in fees

Sometimes it takes money to lend money. At Prosper, you fork over an annual servicing fee that's equal to 1 percent of your loan balance.