Most peer-to-peer borrowers are people who, for whatever reason, were rejected for credit by local banks or financial institutions. However, due to the intricacies of credit score evaluation, many of the people who are rejected for traditional lending are still excellent investment risks. The peer-to-peer lending platform allows these people to seek financing from individuals rather than institutions, with the added benefits of having an individual review the information and take into account the potential borrower’s background and the reasons for any credit issues.
As a lender, though, how does one decide which borrowers are good risks? What do all of those numbers mean, and what should they ideally say? Peer-to-peer lending platforms, such as Prosper.com and related sites, generally offer the following information on any potential borrower. While most have a kind of grading system based on a credit score, the grade alone is not a reliable decision-making criterion.
Just like a bank, the first thing we’re going to look at are the potential borrower’s delinquencies and related negative information. Lending platforms generally give the number of delinquencies for the last seven and ten years, as well as the dollar amount that is still delinquent. In addition, they will show the number of public records up to 10 years ago, which will include any bankruptcies or foreclosures for that time period, and the number of inquiries during the last 6-12 months.
Credit scores are heavily influenced by delinquencies, but the influence is decreased the longer it’s been since a payment was made on the account. In addition, negative information can be outweighed, to some degree, by positive information. Because of this, someone can have several outstanding delinquencies, but if they also have trade lines in good standing their credit score my still be good. They may also have delinquencies they have not attempted to pay on for a couple of years, in most cases those debts have been charged off, and the account has been inactive long enough so as to not impact the score very much. On the flip side, if someone had several delinquencies but worked hard to pay them off over a couple of years and have just finished paying, their credit is still suffering from the negative impact of a recently active delinquent account. As a lender, would you rather have the person who actually paid off all of their debts, or the one who has simply managed to improve their credit score by adding on newer, non-delinquent debt? Automated bank systems will choose the latter, but many individual lenders may prefer the former.
On the same token, bankruptcies and foreclosures have a lessening impact on a person’s credit as time goes on, but many lenders understandably do not feel secure lending to these people. However, someone whose score has been negatively impacted by inquiries while they were being turned down by banks may have never shown any irresponsible or failed management, but their scores may have been lowered by them too much to get a bank loan.
The lending platform should give lenders information regarding the potential borrower’s trade line history, including the origination date of their first line, how many they’ve had total, and how many are still active. In addition, many will show the dollar amount of available revolving credit, and what percentage of those credit lines is currently being used.
The main item to look at here is the percent of credit usage. Credit scores are their best when the usage ranges around 5-20%…on each credit line. If that percentage falls below or rises above that percentage, the credit score is impacted. A peer-to-peer lending platform will show you the total number of credit lines and the overall usage, though some credit cards may be charged way over 20% of the credit line while others are far lower, resulting in a percentage comfortably within the target range, but that might not appear so to banks. In addition, some home equity lines of credit will cause a home’s entire value to show up as revolving credit, with the result that some people may show 90%+ usage when they are really relying on credit cards far less than that.
Credit scores may also be impacted by the number of closed trade lines. Every closed line of revolving credit will impact the credit score, and if someone closes multiple lines in a given year they are likely to see drastic dips in their score. This does not bode well in a bank system, but may appear to the individual lender as someone simply trying to simplify their life and get it under control.
INCOME, EMPLOYMENT, AND HOUSING
Peer-to-peer lending platforms will likely also tell you if an individual is a homeowner, which may go far in establishing their reliability, as well as their income, debt-to-income ratio, in what industry they’re employed, how long they’ve been employed, and their current income.
The work history is useful inasmuch as it reveals some information about the reliability of the person and/or the potential reliability of their income. However, if someone has been gainfully employed at a good wage for 10 years, but their industry is, say, a construction contractor or automotive worker, there may be a risk of future income issues. This is, of course, all subject to a person’s geographical location, the strength of their particular business, and a host of other factors.
Ideally, the debt-to-income ratio will fall somewhere around 30% or less, and many banks will reject applicants that have a higher ratio than that. However, in peer-to-peer lending, a potential borrower has the ability to explain that they’re about to get a raise, that their spouse also contributes to paying the bills, that some of that may refer to a credit line for which the borrower is an authorized user but not primary payer, that the loan will be going to pay off higher-interest bills so the debt-to-income will remain the same, or other such explanations that may influence a lender’s decision.
THE PERSONAL TOUCH
One of the most important things a peer-to-peer borrower gets that traditional borrowers don’t is the opportunity to explain him/herself. Every peer-to-peer listing includes a personal profile of the person requesting financing, as well as a description which tells what the money will be used for, the borrower’s monthly bill amounts, their explanation of how they will fit this payment into their budget, and explanations of past delinquencies.
Armed with all of this information, and knowing the desired target ranges for all of those cryptic numbers with the listing, the peer-to-peer lender can now make an educated decision on whether or not to invest in this particular listing. Make notes of what pieces of information are ideal and which are less-than-ideal, consider the personal explanation, and you’re ready to make your evaluation. All borrowers come with some risks, but by understanding what you’re getting into you can minimize those risks and maximize your returns. Expect to see limited credit records or a number of negative pieces of information for higher percentage rates, and save your lower-percentage bids for those borrowers that meet the ideal requirements in every way.