LendStreet will be launching a peer to peer lending service in the fall of 2011 that aims to help distressed borrowers restructure their debt.

Prosper and Lending Club work with borrowers with 640 credit scores or better. In the early days of peer to peer lending, borrowers with lower credit scores were allowed to take out high interest loans. Unfortunately, no real underwriting occurred and lenders made loans to borrowers at unsustainable interest rates, resulting in default rates that were much higher than expected. As a result, Prosper and Lending Club now have tightened credits requirements for borrowers and many are unable to get loans through those services.

LendStreet will work with borrowers that Lending Club and Prosper won’t touch, but plans on taking a different approach to mitigate default rates. The company will focus on restructuring existing debt rather than providing cash to the borrower.  The money invested by the investors in LendStreet will settle a borrower’s debt with his or her creditors at a discount using money provided by investors on the site. LendStreet will use the difference between a borrower’s total balance and settled balance in a couple of ways. Some of the funds will be used to decrease the borrower’s principal balance, while the remaining portion will subsidize the interest rate that investors receive.

For example, Betty Borrower has $15,000 in debt at 20% interest. LendStreet will try to settle the debt for $8,250 using investors’ money. LendStreet will create a new note to Betty for $12,000 at 9.5% interest. Investors will have essentially bought the $12,000 note at a discount. Betty will repay the new $12,000 to LendStreet will collect and distribute Betty’s payments to the investors that paid for her restructuring loan.

Here’s an infographic which explains the process:

[UPDATE: 5/13/2011 - This infographic was removed at the request of LendStreet.]

LendStreet combines aspects of credit counseling, debt settlement, debt buying, and peer-to-peer lending to help small businesses and consumers restructure their debt while enabling individual investors to collectively buy a borrower’s debt from his or her creditors at a discount. The company also offers borrowers monetary rewards for budgeting and completing financial literacy modules to improve the borrower’s financial management skills. LendStreet’s restructuring terms also aim to contractually prevent borrowers from signing up for additional debt after getting a restructuring loan from LendStreet.

The company’s pitch is that it will leverage the power of social lending to help quality distressed debtors access capital to restructure existing debt, provide fair returns for investors with mitigated risks while making an impact, and helps banks recover more capital for distressed debt while helping their clients and maintaining the relationship.

LendStreet was founded in June 2010 by R. Jerry Nemorin and is scheduled to launch in Fall 2011. It is currently operating out of the incubator located at the Darden Graduate School of Business, which is part of the University of Virginia. The company raised $75,000 in funding and has a strategic partnership with the Financial Literacy Group.

Update 5/18/2011: Peter Renton of Social Lending Network also did a write-up on LendStreet.

Update 5/18/2011: 2 Minute Finance did a short interview with LendStreet CEO R. Jerry Nemorin at Finnovate: