Will lending to a friend take off?
FORTUNE — The first time I wrote about peer-to-peer lending was back in 2007, when, like most other forms of social networking, it seemed like a novel experiment. Companies like Prosper and Lending Club were attempting to disintermediate the traditional banks by inviting individuals to request and make small loans on Facebook-like platforms.
Five years later, peer-to-peer lending has come of age. The nascent industry weathered the 2008 financial meltdown and myriad regulatory issues to become a credible alternative for retail and institutional investors alike looking to make decent returns off their investments as well as a cheaper option for borrowers with high credit scores. And this week, the largest of these companies, San Francisco-based Lending Club saw its credibility rise when the preeminent economist Lawrence Summers, President Emeritus of Harvard University, joined the board. “We’ve had a wave of financial innovation directed at large institutions,” he told me. “I think it’s important also to focus on innovation that meets the needs of consumers.”
Summers joins Kleiner Perkins’ Mary Meeker and former Morgan Stanley CEO John Mack. But Lending Club doesn’t need big names to gain attention at this point. The company issues an average $82 million in loans monthly, and it has now issued more than $1 billion in total loans. Cofounder and CEO Renaud Laplanche, a securities lawyer-turned-tech entrepreneur, recently said he plans an initial public offering within the next 18 months.
The company’s major competitor is San Francisco-based Prosper.com, a similar platform that has issued $430 million in loans so far. Prosper was first to market, but had to close up shop for 6 months in 2009 while the SEC looked into whether its loans should be classified as securities; the pause hurt Prosper’s momentum, but it didn’t take the business down. Now run by former Drugstore.com CEO Dawn Lepore, the platform issues an average $14.5 million monthly in loans and has issued $435 million in total loans.
Most of the borrowers on both platforms are people with high credit scores — the average is 710-715 — who plan to consolidate debt from credit cards, car loans and the like. They can request three or five-year loans with more moderate interest rates than they are likely to find on credit cards. About 10% of the loan requests on Lending Club are accepted.
The lenders are a mix of retail and institutional investors who can choose from among the accepted loan requests to invest; most spread their investments out over dozens of loans to protect themselves against default. (Around 5% of borrowers default, depending upon the amount of risk lenders sign up for.) Because each platform has an active secondary trading market, lenders can trade their investments to liquidate their stakes at any point.
Prosper boasts that investors have seen an average 10% return over the past three years while Laplanche tells me Lending Club investors currently see an average 9% return. One drawback: Peer-to-peer lending is not yet available in every state as each has its own laws about investments and securities as well as its rules about investing. Right now, investors can use these platforms in 28 states.
Though peer-to-peer lending began as an exercise for retail investors, in which one person could literally help out another, about half of Lending Club’s investments are made by pension funds, money managers and other institutional investors these days. Laplanche estimates the figure will rise to 70% as the company grows.
The service will continue to cater to retail investors, however, with a required minimum investment of just $25. And that’s its biggest selling point. To better understand the service, I made a small investment on Lending Club. I liked knowing that my money would support a person trying to pay off a car loan in Monson, MA, a town over from where my mother lives. And I also liked knowing that there may be a new alternative in a down market for my flat-lining money market accounts.