Should you pay credit card debt with a P2P loan?
October 26, 2011
By: Lynnette Khalfani-Cox
Although interest rates are at historically low levels, even the best credit card rates remain in the double digits. So if you're grappling with credit card bills, it can sometimes seem insurmountable to dig out of debt.
To slash borrowing costs and more quickly eliminate debt, consumers are increasingly using alternative repayment strategies, including peer-to-peer lending.
Peer-to-peer or P2P lending – also called social lending and person-to-person lending – involves one individual, or "peer," loaning money to another person, without a bank acting as the middleman.
Peer-to-peer lending is a $1 billion industry, experts say, with loan volume in 2012 expected to triple as banks continue to tighten their credit policies and make it tougher for Americans to obtain traditional loans.
But should you use a peer-to-peer loan to pay off your credit card bills?
Here's what you need to know.
Consolidate high-interest debt
Personal finance expert Jordan Goodman runs MoneyAnswers.com and is the author of the book "Master Your Debt." He's written about peer-to-peer lending and has had first-hand experience with it as well, as an investor, via Lending Club.
Based on his professional and personal experiences, Goodman says that people with credit card rates in the range of 15 to 25 percent or higher would be wise to consolidate credit card bills by swapping out that debt for a lower-rate P2P loan.
"Peer-to-peer loans are a great way for consumers to reduce high-interest rate credit card debt," Goodman says.
The promise of a lower rate is one of the key selling points of P2P loans, industry executives say.
Are you a prime borrower?
Renaud Laplanche is the CEO of Lending Club, the nation's largest peer-to-peer lending network. His company facilitates loans with 3-year and 5-year terms, at an average interest rate of 13 percent.
That can be a good deal for those with significantly higher credit card rates. But Laplanche acknowledges that not everyone will get that rate, or even get approved at all for a P2P loan at Lending Club.
A borrower's rate depends on his or her credit rating, as well as the maturity of the loan chosen. Moreover, Lending Club is very selective about the overall risk profile of its borrowers.
"The unique position of Lending Club is that we focus exclusively on prime and super-prime type of borrowers. Unfortunately, we decline 90 percent of the applications we receive," Laplanche says.
Being ultra picky about its borrowers, Laplanche notes, allows Lending Club to consistently deliver "more predictable" investment returns to the individual investors who fund loans through the company.
To date, Lending Club has arranged cumulative loans totaling $400 million. "We have a goal of reaching $1 billion in loans by the end of 2012," the CEO adds.
Overall, Laplanche says that about 65 percent of loans through Lending Club are for the purpose of paying off credit card debt.
Installment loans boost credit score
Those figures mirror statistics at Prosper.com, another popular social lending network, which has helped roughly $270 million in loans trade hands between borrowers and lenders.
According to Prosper CEO Chris Larsen, between 60 percent and 65 percent of loans on his site are done to consolidate credit card bills.
"These loans represent a very responsible use of debt because they're installment loans," Larsen notes, referring to the fact that P2P loans are not open-ended in duration, like credit card debt. Rather, P2P loans from Prosper require set repayment periods ranging from one to five years.
As an installment loan that is reported to the credit bureaus, P2P loans can also help boost your credit rating. That's because 30 percent of your FICO credit score is based on the amount of credit card debt charged. By reducing or eliminating credit card debt, and turning it into an installment account, you could see an increase in your credit score.
The flip-side, of course, is that a missed payment on a P2P loan will also be reported to credit bureaus, just like any other credit delinquency, thereby lowering your credit rating.
Credit issues aside, Larsen ticks off a host of advantages that P2P loans have over traditional credit card debt. "Credit cards have high rates, fees, and are often variable rate products, so the user could have their rate increased. But with a Prosper loan, the interest rate is fixed, it's an installment loan, and the borrower never faces any prepayment penalties."
None of this suggests, however, that fees aren't a consideration for borrowers on social lending sites. At Prosper, for example, the fee to get a loan ranges from 0.5 percent to 4.5 percent, depending on one's credit.
P2P documents family loans
Doug Flynn, a certified financial planner at Flynn Zito Capital Management, thinks peer-to-peer loans can be of another benefit.
According to Flynn, whose clients tend to be wealthy, one good use of a P2P loan is when it's done to document and formalize loans between family members.
"If someone is going to provide a family member with a loan – to help that person buy a house, pay off debt or for any reason – we absolutely recommend that they get those loan agreements in writing," says Flynn.
Peer-to-peer lending networks can and do formalize such transactions.
Depending on the purpose of a P2P loan, current rates for borrowers can be as low as roughly 6.5 percent – a competitive deal at a time when bank loans are tough to get.
Consider a P2P loan if you think it will help you get your credit card debt under control. Then you may be in a better position to take advantage of the perks offered by the best credit cards.