A few weeks ago I came across a new way to invest and borrow money that I find absolutely fascinating. No, it's not Madoff's newest ponzi scheme or some guaranteed results program. It's called peer to peer lending, and after much litigation it was only very recently made legal under SEC laws, however, currently only residents of certain states can participate (see below).

Social lending is not a new idea, can be traced back to 1750 BC by the ancient Babylonian King Hammurabi.  Since recording data to stone tablets is a bit outdated, now we use the power of the Internet to enable people like you and me to lend and borrow money at our own discretion.  The notion is simple, yet powerful -- both large and small banks should take notice.

You down with O.P.M. (other people's money?)

Currently there are two major players in the American peer to peer lending arena.  LendingClub.com & Prosper.com.  In 2008, Prosper had a debacle with the SEC for selling unlicensed securities (whoops) but has since settled the case and is originating loans again.  In October 2009, Lending Club originated over $6 million in loans while Prosper originated $2 million.
(Source: American Banking News).

Combined, these companies and their social investors have originated over $251 million dollars in unsecured personal loans since 2005!

As a lender, you are investing in Notes. Each Note corresponds to a portion of a consumer loan, and gives the right to receive payments received under that consumer loan, minus a 1% service charge. Most Notes are purchased for a 3 year time period at a fixed rate of return.

As a borrower, one is able to borrow a minimum of $1,000 and up to $25,000.  Each borrower is assigned a credit rating, based on credentials assigned by the lending site you are with (more information on this below). Each borrower will have a story as to why they are borrowing money and what they intend on using it for. Some are consolidating debt, some are starting a new business, some are renovating houses, getting married or buying a car.  Lenders are free to ask the borrower questions about the use of their money and even ask for proof of documentation of finances, cash flow, business operations, etc.

You decide who and what you want to take a risk on.

Interest rates are determined by a bidding process. Lending peers bid on the lowest rate of return they would be willing to lend their money at for each borrower's case and credit rating. Because of this competition, the borrowers get the absolute best interest rate possible as a gauge in confidence in the borrower's rating and use of the money. As a matter of fact, borrowers are currently getting better rates on unsecured personal loans than they may through a bank!

Statistics from Prosper & Lending Club

Keep in mind that Prosper was the first lending site to the market, thus they have more originations.  Also note that Lending Club has tighter credit restrictions for borrowers than Prosper does.  Because of this, you will notice that Lending Club has a lower loss rate, and a slightly better rate of return.

Prosper.com:
$184,000,000 - Dollars Originated Since 2005
38,381 - Loans Originated
$4,794.00 - Average Loan Amount
15.12% - Average Yield
5.60% - Average Loss
9.52% - Average Rate of Return
(Source: Propser Marketplace Performance)

LendingClub.com:
$67,710,000 - Dollars Originated Since 2005
7,458 - Loans Originated
$9,078 - Average Loan Amount
12.58% - Average Yield
3.05% - Average Loss
9.67% - Average Rate of Return
(Source: Lending Club Statistics)

IMPORTANT - You can be a lender only if you reside in one of these states (as of 11/23/09):

Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington, West Virginia, Wisconsin, Wyoming.

The following states are not yet eligible:  North Dakota, Iowa & Maine.

Trading Notes with Other Investors

Both Propser and LendingClub have recently integrated a Note trading platform for lenders to buy and sell debt notes to other investors.  Both sites conduct trading through FOLIOfn, member FINRA/SIPC.  Only Notes that were issued after October 12, 2008 can be traded on the Trading Platform.