When The Bank Won't Lend, Your Neighbor Might

Credit may be loosening for big companies, but it remains tight for little guys. Thanks to social-lending Web sites, needy borrowers can ask their neighbors for a little help online.

The sites charge fees for brokering and servicing the loans (around 1% from the lender and 2% to 4% from the borrower), as well as penalties for late payments. The average loan size is around $7,000; the maximum, $25,000. Terms are generally three years, and rates range from 9% to the upper-teens.

Borrowers can seek loans for everything from debt consolidation to tuition bills to business-startup costs. According to Jim Bruene, founder of NetBanker, which tracks the online finance world, social lending sites make the most sense for borrowers who are self-employed or have other qualities that make it trickier for banks or credit unions to evaluate them.

Social lending sites are different from so-called microlending sites like Kiva.org, a nonprofit organization that allow donors to make zero-interest loans to specific causes around the globe. Kiva collects the money and gives it to a microfinance institution that disburses the funds and hounds the borrowers for repayment. (Kiva doesn't charge interest to the for-profit middlemen, but the middlemen do charge the borrowers.)

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The first social-lending sites appeared in 2005, bringing scale to the age-old idea of borrowing from friends. They multiplied in the latest downturn as traditional pools of credit dried up. When word got out in 2008 that some lenders were getting burned, the U.S. Securities and Exchange Commission stepped in to regulate the industry. Now three big players remain: Prosper.com, Lending Club and GreenNote, which collectively facilitated $62 million in loans in 2009.

While there's no law against borrowing money from friends, family members or even strangers, the SEC had a bone to pick with lenders generating a return on those security-like notes. Regulators hit Prosper.com , the oldest social-lending site, with a cease-and-desist order, arguing that Prosper violated the Securities Act of 1933 by selling as much as $174 million in unregistered securities. Days later, a group of 20 states filed a lawsuit against Prosper for selling unregistered securities. The company has since paid $1 million to settle it.

Borrowers on Prosper must now have a minimum 640 credit score, up from 520. Defaults have ebbed. Before the SEC intervened, 22.5% of its loans had been charged off--meaning that Prosper had not received a payment in more than four months and had since written down the value of those loans to zero on its books. Since the site's re-launch in mid-July, just 6% of its loans have been charged off.

Lending Club does the greatest volume of loans of any social-lending site in the U.S. The site matches borrowers and lenders based on loan size (up to $25,000), risk tolerance and social familiarity--co-workers, fellow alumni, hometown residents and such. After suffering a six-month quiet period, ending in October 2008, the site instituted stricter loan requirements. Borrowers must now have a minimum credit score of 660, up from 520, and a debt-to-income ratio (excluding home mortgages) below 25%. In March Lending Club facilitated 495 loans, worth $2.3 million, all coming due in three years; average interest rate: 7.9%. Default rates are low: Only 2.3% of borrowers have fallen more than 120 days behind in their payments.