What you need to know about Lending Club and Prosper

According to the old saw, bankers once operated under the 3-6-3 rule. They paid depositors 3 percent interest, lent to borrowers at 6 percent, and were on the first tee by 3. But in the wake of the 2008 financial crisis, there's a different route to the country club. Since 2009, bankers have stopped paying any meaningful interest on deposits, and when they do lend, it can be at rates in excess of 10 percent, even to borrowers with excellent credit. (The current annual percentage rate for low-interest credit cards is 10.4 percent, on average, according to Bankrate.com.)

Fortunately for consumers, in this new normal, the laws of supply and demand still hold true. New intermediaries—peer- to-peer lending platforms—are bridging the gap, enabling many people to lend or borrow. Think of them as eBays for money: Just as eBay brings buyers and sellers together, peer-to-peer platforms bring borrowers in need of loans from $1,000 to $35,000 together with investors who want to earn better returns than those offered by banks.

The peer-to-peer platforms grade borrowers based on their credit scores, which are then used to set the interest rates they will pay for the loans they receive. Investors usually don't lend to a particular borrower. Instead, their investments, which can be as low as $25, are pooled together with loans from others.

Once a loan is funded, the peer-to-peer lender issues it to the borrower but takes an origination fee. The amount depends on the grade of the loan. As the borrower repays principal and interest, the investors receive their share of the repayments.

The two largest peer-to-peer platforms, Lending Club and Prosper, have grown from online curiosities in 2007 to a duopoly that has facilitated more than $8 billion in loans, most of it in 2014 alone. It's not a fad: Prosper, for example, is allowed to offer loans in 47 of the 50 states and in Washington, D.C. (Fewer states allow peer-to-peer investing.)

Should you consider peer-to-peer lending either as a borrower or an investor? For some, it may have advantages. The marketplace often functions in a faster, more efficient manner than loan officers at a bank branch. Even so, the risks are similar.

Peer-to-peer marketplaces are relatively new. They're regulated by the Securities and Exchange Commission and are required to register in individual states as well. Lending activities must comply with federal and state consumer lending laws. Here's what to keep in mind before turning to a peer-to-peer platform:

Find out whether investing in Lending Club and Prosper can boost your income.

If you're looking for a loan

• Check your credit score. Your FICO credit score will give you a general idea of what grade you'll receive from Lending Club and Prosper, which in turn will inform the interest rate on your loan. The average FICO score of a borrower at both lenders is about 700. For many of them, their debt could receive a "B" rating and they typically pay an interest rate of 8.67 percent to 13.5 percent on their loan. Some higher-risk borrowers are offered peer-to-peer loans with an annual percentage rate of more than 30 percent.
• Know that there will be fees. Doing business outside the banking system doesn't mean there isn't a cost. Prosper calls them closing fees and Lending Club calls them origination fees, but in both cases, the platform charges you for completing a loan. Fees range from 0.50 percent to 5 percent of the value of the loan, which is comparable to the fees that banks charge for credit-card balance transfers, and they're deducted from the amount of the loan.
• Apply at both. You may find different rates at the two platforms, so make comparisons to determine the better offer.
• Don't ask for more money than you need. You can borrow $1,000 to $35,000, but the more you borrow, the more you'll pay in interest. Larger loans over a longer period of time receive slightly lower grades from peer-to-peer lenders, which results in a higher interest rate. The maximum length of a peer-to-peer loan is five years (three years for some smaller loans).

If you want to invest

• Steel yourself for some level of risk. Remember, you're making an unsecured loan to unknown borrowers. According to Lend Academy, a website that focuses on the peer-to-peer lending industry, 1 percent to 10 percent of three-year loans issued from 2009 through 2012 across all credit risks weren't paid back. That means that investing in higher-yielding, higher-risk loans could put a dent in your returns. In an economic downturn, it's likely that more loans will default, resulting in lower returns.
• Diversify. Both Lending Club and Prosper encourage you to diversify your investments. By lending, say, $50 to 40 borrowers with the same rating, instead of $2,000 to one, you reduce the risk that comes with a borrower who defaults on a loan.
• Use the community. An online network has grown alongside peer-to-peer lending platforms, creating databases and other resources to share wisdom about investing in such loans.
• Remember that your competition is Wall Street. Hedge funds have been taking increasingly bigger bites out of the peer-to- peer marketplace, essentially employing their algorithms to cherry-pick the juiciest loans, leaving the regular Joe and Jane investors with fewer choice loans.