Saturday, February 2, 2013

Peer to Peer Loans - Reducing Transaction Costs

Let's say you had $100 available that isn't needed for any immediate purpose.  You could put it in the bank and earn a little interest, or you could lend to your friend Bob who wants to start a vegan hot dog stand.

Presently, interest rates on savings accounts and certificates of deposit at banks and credit unions are very low - often 1% or less.  But if one were to go borrow money from the bank, it might cost more, perhaps around 5%.  The other 4% goes towards the bank's profit, and a portion also goes towards covering the bank's transaction costs, which include:
  • Staff salaries.
  • Bad debts that never get paid and have to be written off.
  • Office rent and other expenses. 
Now, not satisfied with the 1% interest from the bank, you go to Alex.  Now since Alex isn't able to get a loan from the bank, he's willing to pay a higher interest of 10% a year.  Though he she has a solid business plan, it's such an unusual idea that the bank doesn't have any formulas to use.  It would have to spend staff time analyzing the vegan hot dog market, further adding to the transaction cost. 

Still, it's hard to say if Alex's hot dog stand is going to make it, and maybe you don't want to risk $100 on her.  $10 or $20, maybe.  But now you need to find four other friends who need money and evaluate if they're going to pay it back, and when payment time comes, you need to track them down and hope they don't flake... in short, that's a lot of transaction cost.

At the end of the day, it makes more sense to just put money in the bank, even though you'll only get a measly 1% a year, and the world will miss out on Alex's delicious hot dogs.  Instead, your money goes to fund mountaintop removal coal mining

Net Return refers to net return on investment - in other words, how much money you earn by lending your money out.

Now, along comes online peer-to-peer lending.  A new model less than a decade old, this takes the form of a website where you can lend directly to other people.  The website handles all the payments and other formalities.  You don't need to lend the whole amount, just a portion.  And if not enough people think Alex's vegan hot dogs are a viable business, the loan won't get funded and you'll get your money back.  Equally important, Alex's success in paying back that hot dog loan will determine if she'll be able to borrow more in the future. 

In short, transaction costs are cut dramatically.  Now it's possible to diversify over several loans without having to deal with lots of paperwork.  It's also possible to find potential borrowers much more easily.  Maybe you know that vegan hot dogs are the next big thing.  Alex is only in your town, but you discover on the website that Ben in Portland also has a similar idea.

At the end of the day, more unconventional but profitable businesses get funded, the financial industry still gets to make money (and in fact can now serve additional markets), and you the lender earns more interest.  It's  win-win-win.

This model can also be applied to equity investments, where instead of getting a fixed interest payment, you own a share of the business and get a portion of its profit paid back as a dividend.

Examples of peer to peer crowdfunding include:
Lending Club and Prosper - personal loans
Mosaic - funding solar panel installations

More detailed analysis of these and other crowdfunding websites to follow in future posts.

Note that transaction costs are still somewhat higher for crowdfunding than putting money in a bank, which creates a limitation to this model for folks with lots of money.   This will be explored in the next post. 

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