When the economy is prospering, debt isn’t an issue. You can pay your obligations of today because you know that you’ll be earning more tomorrow and lenders aren’t worried you’ll miss a payment. But as the economy sank last year, you saw a lot of credit card and loan companies scramble to assess the risk of their borrowers. If you had a credit card balance, you might have seen your interest rate go up. If you wanted to buy a house, you may have had to document your income a lot more stringently than you expected. It’s not surprising because the average household credit card debt, based on the Federal Reserve’s Survey of Consumer Finances in 2007, was $3,039.70.

At first glance that may seem a little low, but remember that a lot of people don’t even have access to credit cards. If you only include families with credit card debt, that value goes up to over $7,000. Ultimately, any amount over $0 is too much because credit card companies charge interest rates in the double digits. High yield savings accounts pay out less than 2% these days, so a double digit interest rate on credit cards is far too much. It’s time to pay them down, here’s how.

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Earlier this week, Mark Gimein wrote a great article on TheBigMoney.com detailing, statistically, how risky person-to-person lending really is. I’ve always known it to be peer to peer lending or social lending, but the article calls out the riskiness of Prosper.com, the first and one of the largest of the peer lending networks.

To look at the results of Prosper’s loan marketplace, though, is to see not a solution to the credit crisis, but a microcosm of it. Loans to unqualified borrowers; reliance on mathematical models that turn out to be a lot less useful than they seemed; failed hopes that high interest rates could make subprime loans profitable; sky high default rates—Prosper has it all. Prosper’s Web site advertises returns of 6 percent to 14 percent for lenders. But the reality is that the lenders who loaned $188 million through Prosper have not earned anything like these returns. On the contrary, the majority of them have lost money, as they’ve watched their loans go bad at shockingly high rates.

The takeaway from the article isn’t that you should avoid Prosper, it’s that you probably should avoid peer to peer lending entirely. (In fact, I think Prosper should be lauded for making their loan data public!) There simply wasn’t, and likely isn’t, enough information for you to adequately price in the risk of default. Are things better today than they were in 2007? Probably, but the reality is the peer to peer lending marketplace is a lot riskier than you think.

Whenever there’s something new like this, there’s a subset of its users who will find a way to benefit. For the longest time, the early adopters thought they were the ones who benefited. Unfortunately, as it turns out, the true beneficiaries were the social lending networks (who take a percentage of the loan in fees) and the borrowers themselves (who received loans they probably wouldn’t have qualified for).

When I tweeted this article out, @PotatoPeeler said – “Do we need a whole article to tell us that lending money to random people on the internet is an absolutely horrible idea?” I wholeheartedly agree!

I know people who have been lucky enough to avoid the default plague so far and it seems as though it’s only a matter of time. A little bit of me is now glad that Maryland residents aren’t permitted to “invest” in these loans.

(Photo: nitrofive)

Earlier this year, I hosted a guest post by Jonathan sharing his experiences with borrowing money from peer to peer lending network Prosper. Just recently, I received the following email from a reader singing their praises:

I’ve borrowed twice now from Prosper and I love it. The first loan was $7000 at 8.65% for three years and the most recent was $8000 at 9.65% for three years. I got the 2nd in response to the credit cards jacking up my interest rate and slashing my credit limit no reason. I was so angry about the credit card behaviors that I wanted to get my debts as far away from them as possible.

There is no hassle, I applied for the loan, watched people bid the initial interest rate down, and eventually got the cash. Once the loan was funded, they called me to verify who I was. You have to provide documentation that you are who you say. They direct deposit the money into the account you specify a day or so later.

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I’ve been getting a lot of stories of people struggling to get out of debt because of the recent How to Fight a Debt Collector series. They haven’t reached the point of fighting debt collectors yet and they want to keep it that way. As much as others like to malign those deep in debt, the vast majority of debtors want to make good on what they owe.

If you’re in heavy credit card debt, the first thing you need to do is take stock of your financial situation and stop spending. You need to get yourself on a budget and stop the bleeding. Once you get that under control, the next step is to restructure your debts so you can make up lost ground. That’s where this post comes in.

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When peer to peer lending first started, the biggest name in the market was Prosper. I was skeptical about the whole business of peer to peer lending and it showed in my review of Prosper, which was more about peer to peer lending than it was about Prosper itself. Since then, with the arrival of SEC oversight and other competing businesses like Lending Club, I have a little more faith in peer to peer lending networks.

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Following up on Jim’s guide to social lending networks, this is my story of doing business with Prosper, which is a lot like Lending Club. Although Prosper is in a quiet period, my experience with them is indicative of the basic social lending process, and should mirror what you’d get at other active social lending sites.

I hired a local landscaper and dirt mover last June to correct a horrible grading job in my back yard. For the basic hardscaping (dirt removal, retaining wall, and grading), he quoted $5,000. Of course, I needed the cash on hand. I looked at my local credit union first, which could go as low as 9%. Then I heard about Prosper on Clark Howard’s show, and checked it out. After registering and verifying the usual stuff, I created my loan page. Within a week, my loan had been funded.

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Certificate of deposit rates are abysmal, high yield savings account interest rates are worse, and the stock market is insanely volatile… which is why so many people have started to turn towards social lending networks like LendingClub, Prosper and Pertuity Direct.

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When Prosper first launched, I thought it was a cute idea that had some potential but likely wouldn’t earn my trust. Since then, other companies like LendingClub have launched and the whole peer to peer lending phenomenon has exploded in the news.

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I was listening to NPR’s Morning Edition the other day when they started talking about peer-to-peer lending companies like Lending Club and Prosper (currently closed pending SEC approval).

I’ve written about peer to peer lending a few times before, first when Prosper’s Peer to Peer Lending Marketing debuted and then once again when LendingClub offered their peer to peer lending service.

I personally don’t invest using either service because I didn’t have confidence in an untested system in a totally new paradigm. However, if I were a borrower, I’d jump at the chance to borrow money from individuals rather than the monolithic lending industry. You’d be kidding yourself if you didn’t think the lending industry, be it loans or credit cards, doesn’t jump at the chance to lock you in to something complicated and counterintuitive (option ARMs anyone?).

The borrowers probably benefit the most in this arrangement. The experiences profiled in the Morning Edition clip echo many that I’ve read online – borrowers get the opportunity to get loans with better terms and with less headache. While you are still ranked by your score, you get to add a little color commentary not captured in credit histories.

For investors, I have read that default rates were higher than they first listed and individuals are finally learning why the lending industry acts the way it does. A lot of people default. The benefit of peer to peer lending is that investors can invest small amounts into many loans, thus diversifying their risk. I like the idea of having another avenue to invest in outside the typical stock/bond/whatever paradigm but I’m still apprehensive.

While I’m still not sold on the idea of investing in peer to peer marketplaces, if I needed a loan I wouldn’t hesitate to put them on my list of places to get a quote from. What are your thoughts on the peer to peer lending industry?

In an ideal world, when you needed to borrow some money, you could just walk into your bank and just ask. However, banks are funny in that they generally are willing to give you money when you don’t need it but are less forthcoming when you actually need it. In these harder economic times, those in need of money may be tempted to turn towards other “financial institutions” for short term loans and I’m here to try to dissuade you. These are horrible short-term loans with horrible terms (and their high probability of becoming extremely expensive long term loans) and should be your last resort if you’re in need of cash.

“Refund Anticipation Loans”

These are loans offered by tax preparation firms based on your tax return. They offer them because they know exactly how much of a return you’ll be getting, when you’ll be getting it, and how much money they’ll be making by lending you that money a few weeks early. They’re expensive loans, despite how safe they are, and they’re packed with tons of fees. The industry earned over a billion dollars in 2006, I wonder how many of those dollars were earned from folks who didn’t know they were getting a loan in the first place? Probably more than you’d think.

Payday Loans

Need a few extra bucks to make it through to your next paycheck? How about a little extra scratch so you can get a gift that’s extra special? Payday loans typically have ridiculous high interest rates (think four digits and that’s not counting the decimal places) and their fees are atrocious. The scary part about payday loans is that most people only get one for a few hundred dollars so it doesn’t seem like all that much… then they get socked with fees and then something goes bad and then before you know it you’re going down the mountain with one ski and a prayer.

Credit Card Cash Advances

You might be tempted to stick your credit card into an ATM and simply withdraw some money but take heed. In addition to the interest you may pay by carrying that balance from month to month, cash advances are typically charged an additional fee based on the amount withdrawn. Most credit cards charge 3% of the advance and add that to the amount withdrawn. $100 becomes $103 and, if you carry that from month to month, can have a serious impact. A cash advance is not as bad as a RAL or a payday loan.

Better Sources of Short-Term Money

Need money for the short term? Here are some suggestions, in no particular order, that are better than Payday loans but not exactly ideal themselves:

• Try the bank – you never know.
• Cut other expenses so you’re spending less.
• Ask your employer for your paycheck a little early.
• Borrow from friends and family.
• Consider peer-to-peer lending sites like LendingClub or Prosper.
• Use your credit card for purchases and consider a card with 0% APY on purchases promotion. It’s not ideal but will give you more breathing room.
• If you owe someone money, try to negotiate a deal. Delayed payment beats bankruptcy.

If you’re in good shape now but on the fringe, consider cutting some expenses so you can bolster up the emergency fund. It’s far easier to get money out of a bank account than it is to get it from anywhere else.

Anyone else have any ideas?

(Photo: andrewbain)