Peer-To-Peer Lending For Home Buyers: A New Frontier

The road to home ownership has historically been a familiar one, lined with bank branches, credit worthiness concerns and the dominance of mainstream financial institutions. For many years, the mortgage industry was a fortress, open only to those who could slip comfortably into the underwriting boxes carved out by big banks and government-backed mortgage giants. But with the emergence of fintech, these fortress walls are being breached, and we are seeing a new phenomenon on the horizon: borrowing funds to purchase a home from a pool of individual lenders, rather than from a bank.

Peer-to-peer (P2P) lending, which has become popular for credit card consolidation and small business loans, is making its way into the housing finance arena. Although it is not yet a substitute for the traditional 30-year fixed-rate mortgage, P2P lending is opening up a new space in the real estate market for home buyers to obtain quicker, more flexible, and more human-focused financing for their dream homes. In this blog, we will answer some of these questions and discuss how this new financing model works, the advantages, the risks, and the future of this new type of lending.

The Role of P2P Lending in the Housing Market

At its simplest, peer-to-peer lending is a form of debt financing which allows individuals to lend and borrow money without the intermediary of a traditional financial institution. Sites like Prosper, Lending Club (for the consumer market) and more real estate-focused sites like Fundrise or Ground floor function as online marketplaces to bring borrowers and investors together. This allows home buyers to bypass the costs, red tape and tight lending standards of traditional bank lenders. Rather than relying on a loan officer to judge an applicant against a bank's internal rules, a borrower's profile, creditworthiness, and the characteristics of a prospective home are put out to a crowd of individual investors who can decide to fund part of the loan.

In the case of home purchases, this takes two forms. First is the "fix-and-flip" or bridge loan, in which short-term, high yield funding is made available for investors to expand a portfolio of rental or "fix and flip" properties. The second, more emerging space, is P2P lending for primary homes. In this case, the P2P platform originates, underwrites and services the loan, while the funding is sourced from a pool of accredited or even non-accredited investors looking for higher returns than bank CDs and bonds.

This direct connection between the investor looking for yield and the borrower looking for a home fosters a mutual relationship that is beyond the disconnection of a securitized bank loan. Because of the reduced costs afforded through technology, these platforms can often offer better rates or lend to "unconventional" borrowers from a bank perspective, such as the self-employed with high cash flow but complicated tax returns.

How to Get a Home Loan through P2P

The process of obtaining a home loan via a P2P network is unique and combines traditional underwriting principles with the efficiency and accountability of 21st century technology. The process usually starts with the borrower posting a listing. This is a story, rather than a loan application that gets lost in a bank's internal system. It contains the borrower’s credit history, debt-to-income ratio, and employment information, but also a personal narrative, the reason for purchasing a new home, and, often, a projected return on the investment for the lenders.

The borrower sets the loan size, use of funds (home purchase, renovation, or refinance), and the interest rate they are prepared to accept. This listing is then published for the platform’s investor base to review.

Once published, the loan is ready to be funded. Rather than a single bank or financial institution making a decision to fund the loan, individual investors - who may be high net worth individuals or people with an investment account - view the listings. These investors can invest as little as $10 or $100 per loan, spreading their investment risk across different borrowers. So, for the home buyer, instead of one bank or lender funding the loan, there is a group of investors, each lending a small amount of the principal. The platform pools the money together until the loan is funded.

 Once fully funded, the platform will complete the underwriting, prepare the legal closing documents and fund the loan. The home buyer subsequently pays the platform on a monthly basis, which in turn pays the principal and interest to the individual lenders, less a servicing fee. This can take as little as a third of the time required for a conventional mortgage closing, and some platforms can fund loans in as little as one to two weeks, a huge benefit in an increasingly competitive real estate market where timing can be everything.

Benefits for the Modern Home Buyer

For the modern home buyer, especially those who don't fit the banker's model, P2P lending provides a number of benefits. The biggest advantage is a flexible underwriting process. Banks tend to be rigid, with a heavy reliance on credit scoring systems such as FICO and automated valuation models. An entrepreneur who owns a business but has irregular cash flow, or a young person with a high-paying job but little credit history, are often turned away.

P2P lenders, in putting the borrower's narrative in front of human investors, enable a more nuanced assessment. Lenders can consider not only the borrower's credit history, but also the borrower's character and the investment merits of the property, ultimately financing borrowers who are creditworthy but not "bankable".

Speed and transparency is also a huge advantage. Borrowers are often told that the mortgage process is a "black box": borrowers complete a mountain of paperwork and wait for weeks for a response, only to face a final set of obstacles or altered terms. P2P lenders automate the process, providing status updates and clear rates for the loan originator's fees. This can be critical in hot real estate markets.

A buyer with a P2P loan commitment in hand can often place a cash-equivalent bid on a home, since the loan can be raised rapidly. And because the platform generates revenue from its servicing fee rather than the interest rate spread, it may be less likely to encourage the borrower to pay a higher interest rate. The marketplace model, where investors compete for loans, can put pressure on rates to come down for borrowers with the right credit profile, providing a win-win for the borrower. The democratization of the loan process allows the buyer to be more proactive with his or her finance story.

The Investor’s Perspective: Democratizing Real Estate Investment

The other frontier of this revolution is democratizing real estate investment. Until now, being the "bank" - that is, investing in real estate debt - was the domain of institutions or wealthy accredited investors with deep pockets. P2P platforms have made it possible for the retail investor.

With as little as $500, a person can now be the bank, collecting monthly interest payments that are often well in excess of that available from fixed-income investments such as bonds or CDs. This gives them the opportunity to create a portfolio of real estate investments with none of the headaches of managing a rental property, no bad tenant calls, no leaky roofs, just passive income from the interest they're earning on the mortgage loan.

This approach can also provide investors with the opportunity to put their money to work. Investors using many platforms can select the loans they want to fund based on geographical location, the borrower's background or the property type. A Florida retiree could choose to finance a young family's first home in their home town, positively impacting their lives in a way not possible through investment in a mortgage-backed securities fund.

For the investor, this is done through diversification, funding a small part of many loans to different borrowers in different markets. Even if one borrower defaults, the loan will not have a major impact on the portfolio. This move from passive and invisible to active and visible investing marks a new phase in capital allocation in housing, resulting in a more robust and distributed financial system.

Risks and Challenges: Exploring the New Territory

While P2P lending for home buyers holds the potential to transform the housing market, there are risks and challenges for both borrowers and investors to be aware of. For borrowers, the biggest risk is the cost of capital. The loans are often shorter term and viewed as riskier than conforming loans to banks, so interest rates may be significantly higher. For borrowers using P2P loans for primary residences, these loans are often short-term balloon payment loans (e.g., 3 years), which requires the borrower to refinance to a standard mortgage or sell the home before the balloon payment is due.

Depending on the housing market and the borrower's financial circumstances, they may be forced to sell at a suboptimal time or default. Additionally, because it is an unregulated or lightly regulated industry relative to banks, the kinds of protections that apply to traditional mortgages, like strict guidelines on servicing and foreclosure, may not always be in place.

For investors, the risks are also significant. The first is default risk. Although P2P platforms claim to follow a strict loan underwriting process, these loans are often not backed by the same level of scrutiny as bank loans (particularly for consumer platforms). If the loan defaults, then the investor bears the risks.

The second risk is the risk of platform failure; if the P2P platform itself goes bankrupt, the servicing of the loan may be an issue and the investor may not be able to liquidate their investment. Furthermore, there's no secondary market. While bank loans are frequently sold to Fannie Mae or Freddie Mac, P2P loans are generally not. If investors need to sell their investments, they may have to sell at a discount on a marketplace.

So, before borrowers and investors embark on this journey, they should know that although the flexibility and convenience of P2P lendings is attractive, there is also a greater amount of risk involved.

The Future: Regulations, Innovation, and Mainstreaming

Innovation and regulation is a balancing act for the future of P2P lending for home buyers. As this industry expands, it is inevitably coming on the radar of regulators such as the Consumer Financial Protection Bureau (CFPB) and state banking regulators. The market is currently in a "Wild West" stage but as the industry evolves, we will see greater regulatory clarity that will improve disclosure standards, ensure fair lending practices, and provide guidance on servicing and defaults.

This is both a boon and a curse: we can expect this to boost trust in the sector and open the door for institutional money to flow in, but it could add to the cost of doing business and reduce some of the efficiency and flexibility of the current model. Peer-to-peer lenders that champion transparency and engage with regulators will win in creating a new asset class.

Technology will also play a key role in the future of P2P lending. The use of block chain and smart contracts will bring P2P lending to the next level. Tokenization of real estate assets could allow for even more granular investment and instantaneous settlement of loans. Consider a world in which the mortgage of a home buyer is tokenized on a block chain, enabling low-cost servicing and the instant trading of parts of loans on a secondary market for investors.

With greater sophistication in risk modeling, artificial intelligence will help platforms better price risk, creating a win-win situation of lower rates for borrowers, and more secure yields for investors.

 Although it is unlikely that P2P lending will completely replace the 30-year, fixed-rate mortgage, a uniquely American institution subsidised by the government, it is likely to remain a permanent part of the housing finance system, especially for alternative borrowers, real estate investors and those who need a quick and flexible loan. It is a philosophical shift in the way capital and home buyers connect to provide the necessary funds to build a home.

Choosing the Right Platform: A Buyer’s Checklist

Not all P2P lenders are alike, and for home buyers, choosing the wrong one can lead to a nightmare. The first and most important distinction is between peer-to-peer lenders that focus on "consumer loans", (usually unsecured personal loans) and those that focus on *real estate*.

Borrowing an unsecured personal loan to purchase a home is not recommended because loans are capped in size and interest rates are higher than preferred, plus the funds may not be appropriately structured for a home closing. Home buyers should instead look for real estate crowd funding platforms that are explicitly mortgage lenders, including those that provide bridge loans, home improvement loans, and even primary mortgages. Such platforms are familiar with the complexities of handling real estate, including title and escrow, and property liens.

But more than the type of platform, buyers need to evaluate the platform itself. Select those that transparently disclose fees, both from the borrower (loan origination fee) and from the mortgage payment (servicing fee). It should also disclose the terms of the loan, such as prepayment penalties, late fees, and how the loan will be serviced. You should read reviews from independent sources and research if there is any regulatory action or complaints with the CFPB or state regulators.

Finally, examine the types of investors: platforms that are limited to accredited investors will have more rigorous underwriting and more stability but less flexibility to meet your needs, while those that are open to all investors will have more flexibility. Lastly, inquire about the platform's backup plan: what if they go out of business while your loan is outstanding? A reputable platform will have a loan servicing back-up in place to continue to make your payments and maintain your lien. This due diligence will protect your biggest asset.

Conclusion

Peer-to-peer home finance is not a product innovation, it is a revolution in home buying and lending. By harnessing technology to bring borrowers and lenders together, it bypasses the opacities of the banking system. For the home buyer, it offers access to capital that was previously unavailable to the self-employed, credit-impaired and those looking for a more streamlined settlement process. For the lender, it offers a high return tangible asset class that was previously only available to institutional investors, allowing them to become a direct owner of the value of a property. This mutually beneficial relationship brings a sense of community and unity to the impersonal securitized mortgage.

But, as we begin our journey into the new, we must be cautious. It isn't risk free - we may face interest-rate and credit risk and we may face regulatory risk - the game could change at any time. It's not a panacea; for some, the certainty of the long term, fixed rate, "30 year" mortgage will be the instrument of choice. But for others, P2P lending offers an appealing alternative in keeping with the ethos of decentralisation, transparency and empowerment.

As regulations take shape and technology matures, it is likely to grow from a fringe innovation to a mainstream component of a more multifaceted, robust and accessible system of housing finance. The frontier is being tamed, and this in turn is changing who the lenders and borrowers are, and who gets to be an American dreamer.

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