Prosper: Investing on YOUR Terms

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):

Equation:
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.

More Real-Life Prosper Experience

Here's some follow-up information from Justin McHenry of Zen Personal Finance, who last month posted this collection of comments and reviews from Prosper users.

One of the most-read posts I've written at Zen Personal Finance was the one from last June titled “Why Prosper.com Will Fail”. To be fair, I also wrote a counterpoint to that very post, titled “Why Prosper.com Will Succeed”. The first gets much more traffic and gets mentioned in other blogs and discussion boards, perhaps because it's the second listing if you Google “Prosper.com”.

I have nothing against Prosper and feel a little bad that my negative take on it shows up so high on Google while my thoughts on the potential positives do not (although I linked to the positive post on the negative post).

So, 7 or so months later, I thought I'd look to see how Prosper is doing.

According to this NPR interview with Prosper CEO Chris Larsen, Prosper has over 140,000 members and has funded over $27 million in loans. My thoughts obviously haven't dampened others' enthusiasm.

Here are some other articles and thoughts I drummed up when trying to get a feel for how Prosper is doing today and what its prospects for long-term success might be.

Despite the somewhat derogatory headline “Want to Loan Me Money? Here's a Picture of My Dog.”, this past weekend's Washington Post report on Prosper.com is actually fairly positive on the company. BusinessWeek's “A Tale of Two Lenders”, compares and contrasts Prosper with microloan site Kiva.org, which serves poor communities in Africa and elsewhere.

But forget the media — what are lenders and borrowers saying? Some of what I found (in no particular order):

Scott on Money:

It's now been almost a quarter since I began using Prosper.com. Overall the Prosper experience has been lucrative. My portfolio currently has a risk-adjusted return of over 10%. That certainly beats what you can get currently with both money market accounts and CDs both of which currently will return you around 5%.

As I and many others have previously argued Prosper needs to address the issue of money not participating in loans. For example, I mentioned above that my risk-adjusted return was over 10%. That's only true of the money is actually deployed in loans. If you look back over the past quarter at the overall amount of money sitting in my Prosper account the actual risk-adjusted return is significantly lower because not all of my capital has been deployed into loans.

I know this is been raised over and over and over again. But Prosper needs to provide interest on funds that are not yet invested.

I do have to consider the amount of time and investment takes to achieve the return. Right now, that's my biggest issue with Prosper.

Countercolumn (I don't think this person has actually used Prosper and does not back up the claims made, but the opinion is still interesting):

It's the coolest thing in the world. It's addicting. It's a great little microcosm of capitalism. The lenders are the stupidest people I've ever seen!!!

Why?

Default rates are already, like TWICE what Experian data leads them to believe. Most veteran lenders are underwater. New lenders who haven't learned a thing, but are chasing the illusion of 29% returns are bidding interest rates way down. Lots of borrowers aren't even making it through 3 months without paying late. Lenders are sinking hours into researching trying to beat the odds, but don't seem to be paying themselves a salary to compensate for the time spent in research. There's so many idiots bidding to lend that they're bidding loans down to less than their default rates for a given class of borrowers. There is a shortage of good borrowers.

Blogging Away Debt interviewed the person with the most invested in Prosper loans, about $750,000. He's been pretty happy so far:

Originally, I expected returns of 18% to 20%. I now think my returns will be more like 15%. I am happy with 15%. If my returns drop to 11% or 12%, I'll start moving money back into stocks and mutual funds.

Arctic Orangutan Weblog:

I invested a little bit to try it out. Unfortunately after the better part of a year I am currently only breaking even.

My lack of success is due to intentionally starting out funding risky loans with a higher interest rate. I wanted to start with the riskier loans to push the envelope and see how large a return I could get. I now have a better idea of how to distribute my money.

Moshe's LifeBlog:

For the last 4 or 5 months, I've had a good chunk of change invested in Prosper, and it has been performing beautifully.

Prosper gives me the expected default rates for each credit rating so that I can adjust my requested rates accordingly. Therefore, if I am diversified over enough loans, it is almost no risk because it is entirely predictable, and I'm pretty much guaranteed my desired interest rate of 12%.

I have decided that this is probably the best investment opportunity available at this time, and I'm going (mostly) all in.

Roy:

The biggest problem with Prosper is it takes FOREVER to get anything done. It took 3 days for me to set-up an account and get it verified. It took me another 5 days to transfer funds from my bank account into my Prosper account. Then it took me about a week to get start bidding on listings and for those to close.

A couple of my thoughts based on what I've been reading:

First, I think it's amazing that someone has put $750,000 into Prosper. That would scare me. On the other hand, this person must have a lot of money to play with to even consider such a thing.

Second, I think Moshe is crazy if he is using Prosper as his main mode of investing. It's easy to look at the promising numbers, but just as MLM schemes will tell you what you could make, they don't necessarily correlate with what you will make. Not trying to compare Prosper to MLM, just saying this concept is too new for anyone to making it their main investment vehicle based on potential. This thing's less than a year old, and the numbers they use for predicted default rates are based on traditional loans, not on the actual payback of Prosper loans. Prosper just hasn't been around long enough to reliably tell you what to expect.

Beyond that, though, I guess the reason I haven't been enthusiastic to put any money up is that it all sounds like such a hassle, setting up these accounts and parameters for possible loans, then bidding against others to place your money. I don't have the time for all that. It seems more attractive to someone who really likes to be active with their money, someone who gets as big a kick out of being a “winner” in the system as they do in the actual return. Because your time has a value, too, and unless you think Prosper is a lot of fun in addition to the potential of higher returns, then you have to factor in how much time you're spending when looking at your overall return.

The goal of making lending more “democratic” is great and I hope Prosper can meet that goal. But I'm still not in.

What's It Like to BORROW Money with Prosper?

“But where are the reviews from borrowers?” some of you may be asking. Tricia at Blogging Away Debt has borrowed money from Prosper. Here's her story.

When I first heard about people-to-people lending through Prosper.com last year, a light bulb went off in my head. Would everyday people be willing to lend me money so I could lower the interest rate on my credit card debt?

After some consideration, I signed up. It was a fairly simple to provide personal information via the Prosper website, Borrow Money From People. Low Rates. No Banks.and I did not have to give any proof of my income at this time. (Please note I signed up in May of 2006, so things may have changed since then). I was given a credit grade, and potential lenders were able to see a snapshot of my credit history, including any
delinquencies or non-current credit items. My credit grade was an A, and I didn't have any negatives within my credit history. Unfortunately, I had a high debt-to-income ratio (24%), which I knew would deter some lenders.

The next step was to decide whether to join a group. Groups at Prosper are, in theory, there to help build trust within the Prosper community. Every group has a group leader, and sometimes they assist you with writing your loan request. They can also provide something called vetting. Vetting occurs when the group leader takes a look at records from the borrower to determine that the borrower is truthful. As payment for their “work”, group leaders sometimes get group rewards that are really an extra interest rate percentage that the borrower pays on their loan. Not all groups are not created equal; some group leaders “work” harder for the borrower. Because my goal was to obtain the lowest interest rate possible, I decided to not join a group.

Next I created a listing. I was paying 13% to my credit card company on a balance of $3,500. Because I didn't want a larger loan than I needed, I asked for $3,500. I began by asking for an interest rate of 12%. My rationale was that if even I received the loan at 12%, it was a debt that had a set amount per month to pay and a fixed payback period of three years (although I can pay it back earlier at any time with no pre-payment penalty).

As you may have noticed, I started by asking for a 12% interest rate. This is the beauty of Prosper. Lenders can bid your interest rate down lower and lower by outbidding other lenders. They are competing against each other lenders to fund your loan. However, if a borrower needs the funds quickly and they are not interested in a lower interest rate, they can have their loan automatically funded. Their loan listing will end immediately after the loan is funded. Again, I wanted the lowest interest rate possible so I waited the full 7 days for my listing to end.

It was fascinating to watch bidders with my loan. I actually received two bids for the full amount of my loan request. The first one was outbid. The second one ended up funding a large portion of my loan. When it all over, I had an interest rate of 9.9%, and 13 lenders in total funding my loan. I now have 13 people that want me to succeed because they have a stake in my debt reduction progress. In fact, one of my lenders is familiar with the area where I live and he suggested a restaurant that I should visit once our debt is paid off (to celebrate). That interaction is something that you cannot get with dealing with a credit card company.

My Prosper loan was what I needed to get my credit card debt under a 9.9% interest rate. It was the last piece to my debt consolidation puzzle. I have no regrets about my experience, although in hindsight I could do a few things differently to try to obtain a lower rate.

But as they say: you live, you learn, and you blog about it!

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