We’ve talked a lot about the fact that the credit crunch is affecting everyone. But take a group of people looking for loans at a reasonable rate coupled with a group of people looking for better rates of interest than the paltry sum banks are offering these days, and you get person-to-person online lending.

In case you’ve never heard of this, it works like so. A borrower can go onto an online lending site - like Prosper or Zopa - and request to borrow a specific amount of money for a specific amount of time. Then they’d list the max interest rate they would be willing to pay. From there, lenders will then bid on the requested loan amount. Most lenders will only lend any one person $50-500 because there’s a certain amount of risk for them if the borrower defaults.

These third party websites hosting the transactions between lenders and borrowers do a lot of the leg work for the lenders. They run the credit score of the borrower and assign a risk grade based on the score. That risk grade is shown to lenders and from there they can make their decision on how much, if any, to lend to that specific borrower. The websites also take care of the disclosures, paperwork, and collecting and distributing of payments in most cases. There’s also a bunch of U.S. regulations that these companies have to go through, so it’s perfectly legit. They’re licensed lenders and registered with the SEC, and some of them even have direct relationships with certain credit unions to make things more secure.

The benefit to lenders is of course the higher rates of interest. The minimum loan that these sites usually allow is $50. As I said, most lenders spread the risk a little bit so they don’t take such a large hit if one borrower defaults, but many people on these sites looking to borrow are there because they can’t get loans through the normal channels. So, they’re willing to pay higher rates of interest just to get the money they need. As a lender, you could potentially have a borrower paying you 18% interest for one loan, which is marginally better than 3% at your bank. And even if you have multiple borrowers that you’ve lent to, you’re still likely to have higher returns than what the banks are paying.

The companies providing this service to people are expecting over $100 million dollars in loans this year as people borrow to pay down their credit card debt, use the funds in lieu of student loans, and various other needs that arise. According to a study conducted by Javelin Strategy and Research, the number one reason people want to engage in person-to-person lending is to pay off credit card debt.

Neat concept, but does it work? Well, my coworker lent out $1000 on Prosper. She chose her borrowers very carefully and she never lost anything. Both of her borrowers paid their payments on time every month. Other lenders have reported equal amounts of success, citing only that some borrowers paid late on occasion, but their payments were always made.

Not having tried this either way, you’ll have to take my opinion with a grain of salt. I think it’s a great concept for those willing to take a little risk and lend to complete strangers. You can get some great returns on your money and unfortunately, banks just can’t compete with that. However, for borrowers, I’m not so sure that it will always work out to their advantage. Sure, they’re likely to get a loan when they really need it - and in those situations, that’s great - but someone with a 660 credit score can get a better rate than 18% with a bank. My suggestion would be to weigh the options and the interest rates and see which route is better.

I also don’t think this kind of lending should be for student loans. While I understand that the student loan companies are cracking down on their lending policies, at least through them payments are deferred until after graduation. With person-to-person lending, the due date is set from the date of closing and then you’re required to make your payments. Ultimately though, there are things both good and bad about such a venture.

I’m curious to know what you think - especially from those who’ve participated with these sites in one way or another. Would you borrow from such a forum? Would you lend?