Note: I’ve received many questions about Prosper, but I’ve never used it. Here’s a post from Frykitty, the very very quiet second author at Get Rich Slowly. She recently set up a Prosper account and has written to share her experience.

Last December I discovered Prosper, a site that connects private lenders and borrowers, and manages the resulting loans. Because I’m not a fan of the stock market, this looked like a perfect opportunity to invest on my terms, to help individuals with faces and stories, rather than contribute to the bottom-line culture. I decided to start the new year by testing Prosper with a set amount of funds to see how it performed.

Borrowers sign up on Prosper, then post a request for a loan and the maximum amount they’re willing to pay in interest. Lenders then bid to fund all or part of that loan, at an interest rate of their choosing. You win a bid by coming in at a lower interest rate than your competitors.

Prosper Tip #1: Patience is a virtue.
I signed up with Prosper on January 1, 2007. Because there was no space for a mailing address in addition to a home address, there was a small verification problem that required some faxing, and that took me a few days. On January 3, I was approved as a lender. To bid on an account, you must have funds in Prosper. I immediately added an account and initiated a transfer of $500 to begin my experiment. On 1/5, I saw the money leave my bank account. On 1/9, the transfer was finally complete, and I was able to bid. Yes, that’s almost 10 days between signing up and being able to bid. That’s a long time in Web years. Prosper has recently made some changes to their customer support and approval processes, so this wait may be shorter in the future.

At last I was able to bid. I decided to fund 10 $50 loans, two each in five credit ranges. At the time, Prosper credit ratings went from AA to NC (no credit history), with the lowest rating being HR, or High Risk. Prosper recently changed their ratings, raising the credit scores for E (560-599) and HR (520-559), and they no longer allow listings from those with a lower score than 520, or no credit history. While I liked to help out those NC folks, apparently other lenders showed little interest. I did bid in time to fund two NC loans, and also two each of A, B, C, and D. I passed on E and HR.

Prosper Tip #2: Bid on loans that are already 100% funded.
Lenders can bid on loans for a specific amount of time, kind of like an eBay auction. If there is a lot of interest in the loan, many lenders will bid, covering the entire amount of the loan. Unless the bidding is set to be automatically ended when the loan is funded (rare), you can still bid, as the idea is to get funding at the lowest interest rate possible for the borrower. Lowball a little — put in an interest rate you still like, but that is a point or two lower than others are bidding. Chances are, you will get to fund part of that loan.

When you bid on a brand new listing, or one where little interest has been shown by other lenders, the listing will often go away when the amount is not funded, leaving you to start the process over.

Once the bidding has ended, Prosper verifies everything, then funds the loan. This can take as long as a week. One loan on which I won the bid was cancelled before funding, as Prosper was unable to verify all information regarding the borrower. Prosper is very, very careful about fraud, and they err on the side of caution, an attitude I appreciate enough to put up with the extra time it takes to get through the process.

Prosper Tip #3: Remember: you’re the bank.
Once my loans were all funded, it was time to watch the payments roll in. It’s something like watching a garden grow. All Prosper loans are on 3-year terms, with the borrower making monthly payments due beginning one month from origination. The borrower may pay extra principle, and can repay the entire loan at any time with no penalty. This is where it’s important to remember that you are playing bank, and it’s different from other investments and from savings; while the loan carries a specific interest rate, that is not your ultimate return. As with a bank loan, taking the full term to repay works in the bank’s favor. Cribbing from Prosper’s excellent FAQ:

Interest and annual servicing fees are accrued daily, and are based on the current outstanding loan principal.

To calculate the daily accrual amounts, take the principal balance on any given day and multiply it times the daily rate (based on a 365-day year):

Daily accrual = (Annual rate / 365) * Principal balance
For example, if you own $50 of a loan with an annual interest rate of 10%, you will accrue $0.0136 in interest on a daily basis, and $0.00068 in lender servicing fees (which have an annual rate of 0.5%). Keep in mind that as the principal balance drops (because the borrower makes payments each month), the rate of accrual will also slow over the life of the loan.

Assuming a full three-year loan, your $50 loan at 10% interest would earn you $8.12 in total interest, and you would pay a total of $0.41 in servicing fees.

To get historical numbers, study Prosper’s Marketplace Performance charts. This gives a very useful picture of the default rate as well. Default is your primary risk with Prosper, and you can manage that risk by researching the different credit grades, examining the income-to-debt ratio of the borrower, and any other factors which may affect repayment.

So far, I have only a few dollars in my Prosper account, as most of my loans originated less than a month ago. Once I have another $50 in my account, I’ll bid on another loan, continuing to reinvest. I won’t have a good handle on the ultimate performance of Prosper until my initial loans are repayed, and I can see how the investment has performed over those three years. At the moment, I have 10 active loans with an average interest rate of 13.99%, and all are current, with several of them processing payments. These first payments are like watching those first crocuses bloom. I hope I’ve planted some sunflowers.

Look for additional information about Prosper later today. Frykitty has also contributed reviews of Your Money or Your Life and Start Late, Finish Rich. She is the mastermind behind the blogathon. She also does a terrific job of feeding me story ideas for Animal Intelligence.

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