The online sites Prosper, the Lending Club, and others offer credit to small business owners in a way that wasn’t available a decade ago – by matching borrowers directly with individual lenders, cutting out the bank as middleman.
While still a miniscule slice of the $1.1 trillion of outstanding small business credit (PDF), peer-to-peer lending, as this type of financing is known, has grown rapidly since its introduction in the mid-2000s. A Federal Reserve Board of Governors’ report (PDF) to Congress indicated that the value of small business loans provided by the two major largest sites – Prosper and the Lending Club – nearly tripled between 2011 to 2012.
While some observers believe that peer-to-peer lending will someday replace much of bank lending to small business, right now it isn’t a true alternative to most small business bank loans. Rather, it’s substituting primarily for credit card borrowing by small business owners.
Replacing credit card debt hits the sweet spot of peer-to-peer lending – swapping cheaper debt for more expensive alternatives. Federal Reserve Board research (PDF) indicates that approximately half of Lending Club loans are for debt consolidation.
Peer to Peer Loans
Peer-to-peer lending faces several obstacles to becoming more than just an alternative to credit card loans. First, it is expensive. According to the analysis by researchers at the Federal Reserve Board of Governors, the average interest rate paid in 2012 for a small business loan at The Lending Club was 13.4 percent. That’s substantially higher than the average short-term small business bank loan interest rate of 6.3 percent reported (PDF) by the National Federation of Independent Businesses for June 2012.
Because peer-to-peer lenders charge higher interest rates than those on small business bank loans but lower than those credit card debt, peer-to-peer lending is a more attractive alternative to credit card borrowing than to other bank loans.
Second, loans from peer-to-peer lenders tend to be small. The Lending Club caps loans at $35,000, and its average small business loan was $16,200 in 2012, analysis by the Federal Reserve shows. That’s not far off the average small business credit card loan of $11,639 when measured in 2012 dollars, Federal Reserve Survey of Small Business Finance data (PDF) show.
Thus, peer-to-peer lending provides a different way to obtain a similar amount of money that many small business owners get by maintaining balances on their credit cards, but not enough to replace the amounts that they typically tap from banks.
Third, peer-to-peer lenders don’t provide collateralized loans, generally offering only unsecured credit. That makes it difficult for peer-to-peer loans to replace small business bank loans backed by business and owner assets, like vehicles and equipment.
Fourth, getting a peer-to-peer loan is more similar to obtaining a credit card loan than a traditional bank loan. The low-level of paperwork involved, the heavy focus on personal credit scores in the evaluation process, and the quick decision making timeline lead borrows to think of peer-to-peer loans similarly to credit card debt.
Peer-to-peer lending is a new source of small business finance, and is likely to continue to grow substantially in the future. But for now, it appears to be substituting primarily for small business owners’ credit card borrowing rather than the traditional bank loans.
Peer-to-Peer Photo via Shutterstock