A YEAR AGO

, Nicole Newberry was in a financial hole so deep that she had trouble making the minimum payments on her credit cards. Worse, the then 22-year-old had gotten tangled up in the predatory cycle of payday loans. Every two weeks, when she repaid the two loans she owed, she borrowed the money right back to pay for groceries and diapers for her two toddlers. Her predicament was cruelly simple: "Each month, I was making all these minimum payments and getting nowhere," she says.

Then a co-worker told her about Prosper.com, a peer-to-peer lending web site that facilitates loans between strangers. Consumers seeking a loan list the details of how much they need and why, while those with cash to spare scour the listings and make loans to the ones they choose. Generally, borrowers get lower interest rates than they would with a bank or credit card, while lenders can earn better returns than they would in a money market or savings account.

Within 10 days of posting on Prosper, Newberry received a $9,000 loan at 19%: Enough to pay off the pesky payday loans and all her credit cards, which at that time carried 25% to 27% interest rates. As a result, her monthly payment dropped significantly, to $330 from $800 before consolidation. Her credit score, once a subprime 580, is now 680 and steadily rising. And then there's the 1,800-square-foot icing on the cake: Three months ago, Newberry purchased her first home, a four-bedroom house in Sacramento, Calif.

With the surging popularity of peer-to-peer lending sites, feel-good stories like Newberry's are becoming increasingly common. Since its launch in February 2006, Prosper.com has facilitated $90.5 million in loans among nearly 440,000 individuals. LendingClub.com, which launched in May exclusively for users of social-networking site Facebook, opened up its services to all consumers in mid-September. Now the site has 20,000 users and has handled more than $1 million in loans. Starting Oct. 15, CircleLending.com, which sold a majority stake in the company to Virgin USA in May, re-brands itself as Virgin Money. The site manages more than $200 million in loans between friends and family.

Eliminating the bank or credit-card issuer as the middle-man isn't currently the norm, but it's gaining momentum, says Christine Barry, research director of Aite Group, a financial industry research firm. The credit crunch and soft housing market combined have all but killed the idea of using home-equity loans to refinance high-interest credit-card debt and homeowners looking to refinance high-interest mortgages are unable to do so if they have less-than-pristine credit records. And small-business loans, always hard to get from traditional banks, have pretty much dried up.

The result: People are seeking financing from, well, other people. At Virgin Money, loan volume in the past six months has been growing twice as fast compared with the pace last year, according to Asheesh Advani, Virgin Money's CEO. (This is also partly due to the acquisition of CircleLending by Virgin USA, he notes.) At Prosper.com, $62.1 million in loans changed hands year-to-date, compared with only $16.8 million during the same period last year.

But the allure of peer-to-peer lending goes beyond better interest rates and improving one's bottom line. These web sites have become somewhat of a mix of Match.com, Facebook and eBay, with emphasis as much on social networking as on closing a deal. Being part of a group, whether it's an alumni association, employees of a specific company or simply being a friend of a friend, plays a big role. At Prosper, users can create groups that, based on members' repayment history, receive star ratings and can help borrowers get lower rates. At LendingClub, lenders pick borrowers based not only on their credit profile, but also on their affiliations.

"Peer-to-peer lending reminds me very much of the credit union model," says Aite Group's Barry. "You're usually lending to people that belong to the same kind of affinity group. There's a certain degree of trust."

And then there's the fuzzy feeling of helping ordinary people fulfill their financial goals, whether it's getting out of debt, fixing a roof or purchasing a dream wedding dress. "You, as the lender, can feel like Jimmy Stewart [in the movie "It's a Wonderful Life"] and invest in people who you know, and fight the evil banks," says Andrew Nelson, a 48-year-old freelance writer in Alpine, Texas, who has so far loaned more than $20,000 to more than 500 people on Prosper.com. When searching for borrowers, Nelson says he looks as much at their "numbers" a borrower's credit rating, loan-to-income ratio and repayment history on other loans as the stories behind them. "If I trust the story, I'll lend the money," he says.

To be sure, peer-to-peer lending doesn't come without risks. For lenders, the biggest danger is default. Of the $3 million lent through Prosper.com in September 2006, for example, $300,000 in loans have already defaulted and more than $200,000 are two or more months late, according to WiseClerk.com, a web site that tracks Prosper.com activity. Default on mortgage loans taken through Virgin Money is impressively low 0.5% but that's because most troubled borrowers choose to restructure loans, for example by tacking missed payments onto the unpaid loan balance. Because their lenders are close friends or family members, "people restructure all the time," Advani says.

For borrowers, meanwhile, there's no guarantee they'll find the money they need. Generally, the basic principle of lending applies here as well: The lower your credit score, the lower your chance of getting financed. (Both Prosper.com and LendingClub.com employ letter grades to assess borrowers' credit worthiness, based mainly on credit scores.) According to WiseClerk.com, of the 14,534 Prosper.com loan listings for borrowers with a "C" rating that's for borrowers with credit scores between 640 and 679 only 2,668, or 18%, have been funded. Of the 4,608 "AA"-borrower listings, meanwhile "AA" are borrowers with scores of 760 or higher 1,557, or 33%, have been funded.

To make sure her $9,000 loan request got noticed, Newberry shared as much personal information as she felt necessary about why she needed the money and how she would repay them. She even included photos of her with her children and listed the grades for the college classes she attends. She patiently and truthfully answered all questions from potential lenders. "You can't be rude or defensive," she says. "You have to put all your business out there, be honest, and it'll pay off."