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When Thomas Jefferson said, “Never spend your money before you have earned it,” he probably did so in accordance with the traditions of the time. While that prudent advice still remains a desirable ideal today, it is no longer a paradigm cast in stone for our modern era. The fact is financial concepts have evolved, such as with the onset of person-to-person lending. Within reason, it could actually make sense to spend your money before you have it. Let us explore two cases.

1. Borrow when something is self-liquidating

This is the best possible case for borrowing—when you can practically acquire something for “free” because you can pass on your debt payments to somebody else. An excellent example of a self-liquidating transaction which you can enter into using borrowed money is to purchase a commercial property which you can lease to a tenant. Ideally, the rental income you receive should cover your monthly mortgage repayments, property taxes, insurance premium, property maintenance expenses and a surplus amount for you as well.

As long as you break even, it still makes sense to borrow without the left-over surplus because you acquire ownership of said property after you fully pay your mortgage. Unless you erred seriously in the choice of your location, since property values generally appreciate with time, you can realize your profit later when you sell the property.

2. Borrow when something appreciates in value over time

This is the next best case for borrowing, where gratification is delayed a bit but still highly probable. Consider a variation of the above example -- a non-commercial situation where you borrow to purchase something for your own use, like a house for your residence. This is a case where your gains do not come immediately in the form of a subsidy on your mortgage repayments from monthly rent payments.

The benefits take a little more time to earn in the form of your accumulating home equity and appreciating market value. However, the moment your home equity grows, you can leverage it for borrowing purposes, even if you still have an outstanding mortgage on your house. Alternatively, the market value of your house could also appreciate to a level where you could sell it to pay off your outstanding mortgage, recoup your financing costs and gain a tidy profit at the end of the day.

Although my examples have been in the real estate arena, the universe of possibilities is by no means limited to the property market. You can borrow with Lending Club to start a small business, buy a machinery or equipment that you can rent out, and so forth. For as long as your “project” satisfies either of the two above-mentioned categories, your borrowing makes sense.

It’s safe to say that we all want our money to earn the highest possible interest rate in the P2P marketplace. How do we know when an interest rate is not right for us or when it is too good for our own good? Is there a framework that can help us answer this question?

Since P2P lending is Web 2.0 retail bank lending minus the bank, let’s look to traditional banking for some ideas. Each bank has its own in-house loan pricing model. However, banks use the following models to determine what interest rate to charge their borrowers:

• Cost-plus Pricing. In this pricing model, the interest rate charged on a loan has four components:
cost of funds (interest cost on deposits or money market borrowings used to fund the loan);
cost of servicing the loan (application and payment processing, wages, salaries and occupancy expense); risk premium (default risk inherent in the loan); and profit margin (adequate return on bank capital).

The latter three items can be bundled into what bankers call a “spread,” expressed as a per annum rate, to simplify its use in the pricing formula. Thus, you can look at a quoted bank lending rate (say, 10% p.a.) as consisting of a cost (say, 6%) plus a certain spread (say, 4%).

• Relationship-based Pricing. Under this approach, a “prime” or base rate is established by the bank for its most creditworthy customers on short-term working capital loans. The prime rate, once established, becomes a benchmark for many other types of loan products of the bank.

To maintain an adequate business return using this approach, a bank adds a spread (as discussed above) when lending to non-prime borrowers, in a way that would keep its funding and operating costs and risk premium as competitive as possible.

• Risk-based Pricing. This pricing scheme is decidedly more complex than the previous two because of the variety of risk-adjustment methods that are currently in use. Most of these are too technical to explain and are not relevant for our purposes here at Lending Club.

Lending Club uses a leading-edge risk-adjustment-based method with a credit-scoring system to set an appropriate default premium when determining a potential borrower’s interest rate.

With risk-based pricing, a borrower with better credit will always get a lower rate, due to the expected lower losses to be incurred from his account. With this pricing method, less risky borrowers do not subsidize the cost of credit for more risky borrowers.

Knowing about the various loan pricing methods, you can better understand how professional bankers price their loans. You can now also approach P2P lending more scientifically than before.

One conclusion you should draw is that on Lending Club, borrowers can receive lower more competitive rates than they would get from banks. Lending Club does not have the large cost structure that banks face.

Another conclusion we can make is that there is no right or wrong method. To take it to the extreme, if you lend money elsewhere you can opt to be totally arbitrary and devoid of any method when deciding on your loan rate.

If you set your loan rate with a willful disregard for credit risk in order to attract or retain borrowers, you will be engaging in an unsafe and unsound lending practice. Instead, lend on Lending Club where you will benefit from the most advanced methods to set a reasonable rate that will allow you to earn money at relatively low risk.

You want to be your own banker? Fine. Now that you’ve joined Lending Club to either lend or borrow, see if you know what bankers know and if you’d like to think how they think. I’m not suggesting that there is only one way to think about money.

Banking—lending—is over 4,000 years old, why reinvent the wheel when we can benefit from the structured knowledge that has worked for so long? The oldest recorded bank loan, inscribed on a clay tablet found in the temples of Babylon around 2,000 B.C..

This involved two shekels of silver borrowed by Mas-Schamach son of Adadrimeni, from the sun-priestess Amat-Schamach daughter of Warad-Enlil, at the Sun-God’s interest, payable at the time of harvest.

Having said that, a good place to start your person-to-person lending education is with the four C’s of credit. Other C’s have been added over time, but these four (actually three, as will be apparent later) are enough for your purposes here at Lending Club:

1. Character. Character here refers to a person’s attitude and personal values in relation to his or her credit commitments. I would like to underscore the phrase “credit commitments,” because as long as the applicant has consistently met credit obligations, his or her personal lifestyle should not get in the way of your lending decision.

2. Capacity to Pay. For an employed applicant, capacity is estimated using disposable income versus the amount of the proposed monthly loan payment. For a self-employed applicant, the net business income, stability of the business, and the person’s managerial ability are considered.

3. Capital. Capital pertains to a borrower’s assets. A person’s properties and other valuables are indicators that the applicant has sufficient resources to live a good life and make a good living. The logic here is that a homeowner is more likely to be a good borrower than somebody who is not similarly situated.

4. Collateral. Sometimes, personal property and other assets can be used to secure a credit obligation. Collateral provides a motivation for the borrower to repay the loan, as well as a source of repayment for the lender if the borrower is unable to pay back the loan. Since Lending Club loans are unsecured at this time, collateral is not your direct concern.

These principles should serve you well as a borrower or a lender on Lending Club.