Peer-to-Peer Lending and Entrepreneurship

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Recent years have seen the rise in peer-to-peer lending, with entities like providing a way for people to borrow money from individuals they don’t know rather than from banks and other financial institutions. A good portion of this money is being borrowed by entrepreneurs to finance their businesses.

The growth of peer-to-peer lending, and the participation by entrepreneurs as borrowers, is an observable fact. And the reason why entrepreneurs go to peer-to-peer lenders makes a lot of sense. Entrepreneurs are able to get funding for their businesses from individuals even when they can’t get them from financial institutions.

The question that’s puzzling is why individuals lend money to entrepreneurs that institutions won’t finance. We don’t have any carefully done studies that answer this question, but here are some possible explanations.

1. The lenders are foolish. Individuals have less stringent criteria for making loans than institutions because they know less about the risks of lending money to entrepreneurs. And they gather less information on which to evaluate different borrowers. As a result, they make loans that aren’t very good and have poorer performing loans than banks or other institutions would tolerate.

2. The lenders have low return expectations. Because institutions have higher costs than individuals (who aren’t paying salaries to loan officers, managing bank branches, or paying interest on deposits), the individuals are willing to make loans at a reasonable interest rate. To make the same loans, banks would have to that charge such a high interest rate that usury laws prevent them from making the loans.

3. The transactions costs are too high for institutions. Individuals can make small loans that institutions can’t afford to make because they have much lower administrative costs. So individuals make them and institutions don’t.

4. The lenders find it enjoyable. Individuals often do things for personal satisfaction that company managers, who have to act in the best interests of their shareholders, can’t do. Lending money to other people in need might be fun or might provide a feeling of emotional satisfaction. Thus lenders get non-financial compensation and don’t really care about making money. Banks, and other institutions, can’t make the same trade-offs of non-financial for financial compensation and so don’t make the loans.

Why do you think individuals will lend money to entrepreneurs that banks and other financial institutions won’t finance? I’d be interested to hear your thoughts.

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About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of seven books, including Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures.

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Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

11 Reactions
  1. “Individuals have less stringent criteria for making loans than institutions because they know less about the risks of lending money”

    You’d think that, but looking at the state some of these institutions are in it’s hard to believe they understand risk either.

  2. I think what Prosper succeeds at most is lending for things that banks wouldn’t necessarily lend for at all. We went there to get money to cover our move. I had the credit available on my credit cards but got the loan through Prosper at a rate about 5% below my credit card. I was a good credit risk, the amount of the loan is a pittance compared to my income, so it works out well for us, but I imagine less so for many people. We haven’t missed a payment so far unless you count the time Prosper’s phone people couldn’t actually get my bank accounts switched properly so it tried to take it out of a closed account. :/

    But we’re unfortunately a rare example from what I’ve seen. The bulk of the people on Prosper seemed to be asking for money with no real idea what reasonable interest rates are and whatnot. Just glancing I see somebody who obviously has a very healthy income, but yet they’re asking for over $20k at over 20% for a business loan! I’ve never heard of a small business with a solid plan paying at anywhere near those kinds of rates. Either the borrowers aren’t very smart or there’s something going on there that they aren’t saying, and neither bodes very well to the lenders. But I can see why people lend–it’s like why people play the lottery. Who *wouldn’t* want to get 20% on a relatively small investment?

  3. I like to think that the “low return expectations” by peer lenders and “transactions costs are too high for institutions” are the most likely reasons.

    It’s not worth the time and money of big institutions to lend to the little guy but individual lenders do take the time to review the loan requests and look for promising opportunities.

    Here’s a free resource for people who are interested in learning more about successful lending strategies:

  4. I like to think that these people are either entrepreneurs themselves or “entrepreneur wannabes”. The first group understands the dilemma of the small business startup and want to participate. The second group can’t quite take the leap but this is a way of getting involved with very specific and known risk. If it works, maybe they’ll step out and try it.

  5. Scott or anyone commenting,

    Do any of you know the story about micro-lending to small businesses. I am trying to get more educated on this topic after one of my guest inquired about this topic.

  6. Scott,
    None of the reasons you give make any sense to me.We at Kenny Consulting Inc see a completely different picture of entrepreneurs seeking working capital or,for that matter,investment capital (start up funding) which raises,in my mind,some very interesting questions regarding what Susan posted on her response to you.True most people have unrealistic expectations as to what they will have to pay for a small business loan,in some parts of this country folks have not YET heard the word RECESSION,but what Susan and many others fail to take into account is the the RISK level that a loan to an entrepreneur,no matter how good his business plan or credit rating is! No one in his right mind will lend money for sheer non-financial satisfaction unless it’s his or her own money to burn,lenders and ALTERNATIVE lenders cannot do so if they are planning to be around for a while!

  7. Peer to peer lenders are not foolish. Peer to peer lending involves making lots of small loans to different people, which spreads out the risk. Lenders can make a healthy return from offering fair rates, unlike institutions that take advantage of consumers with 20+% rates.

  8. peer to peer lending offers solutions for those who cannot get traditional financing, however it appears that this process circumvents traditional financial industry regulations.
    What checks and balances are in place to prevent people from using this avenue to launder money, provide financing for illegal activities etc. Comments and thoughts are welcome .

  9. THis is an interesting conversation. I’m doing some research as I am potentially going to lend an entrepreneur I don’t know well $10,000. Why? I heard her story from a mutual friend and was fascinated by this woman’s skills as a business person. Her need for capital at this time makes sense (expanding her business, needs to purchase raw materials and due to the bad credit of former owners, must pay COD) and her capacity to make the money back in short order seems fairly risk free. I am compelled by the fact that: 1. I currently have money that is not making a great return and is liquid, 2. I want to help this woman 3. I want to make more money in a passive way. When I have money, I seem to offer it to people because I like the idea of filling a need. So far, noone I’ve offered to loan it to ( 1 brother, 2 sisters and my partner) have taken me up on it. I feel like I’ve been lucky and well-supported in life and I want to help others – return the universe’s favor so to speak. Plus there is some truth to what a previous commentor said: I love entrepreneurs – and I love the risk this woman took on. I also own a small business, but have NEVER been in the red because I keep it pretty small and simple. I dream big, but haven’t take on any significant risk except opening it in the first place. Yeah – I love her spirit and want to see her do great!

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