Taking the Plunge with Prosper.com
I was intrigued enough by the research I did for my article a couple weeks ago that I decided to open a small lending account at Prosper.com, the peer-to-peer lending company. It's been an interesting experience so far, and I'm still learning a lot.
In no particular order, here are some of the things I've discovered so far:
On average, Prosper.com lenders tend to charge too little interest on the riskier loans: the interest rate isn't high enough to compensate for the higher risk of default (and often isn't high enough to make the expected return match the lower risk loans). For example, if lenders expect 8% interest on a low-risk loan with a 0.5% expected net default rate (i.e. on average lenders lose 0.5% of their principal to defaults on loans of that class), then on a loan with a 5% expected net default rate the lenders should charge significantly more than the 12.5% interest which would make the return the same as the low-risk loan. But that's not what happens on average on Prosper.com; instead lenders are asking less (sometimes a lot less) interest on those risky loans than you would expect. This means that if you're a high-risk borrower, Prosper.com is a great deal for you if you can get your loan funded.
That said, there is a surprisingly wide range of interest being charged on similarly risky loans: I've observed as much as six percentage points difference in the rate charged for loans which (as near as I could tell) were about equally risky. So, if you're a borrower on Prosper.com, sometimes you win the interest rate lottery and sometimes you lose.
The name of the game in lending is minimizing default. You only earn 7% to 25% interest on your loan, but if the borrower doesn't pay you can lose 100%. A single bad loan can destroy your performance, unless you've got at least a hundred or so different loans in your portfolio (this implies, by the way, that you need to invest a minimum of $5,000 to $10,000 in Prosper.com if you're going to be serious about it, since the minimum slice each lender can have of a single loan is $50). Any loan can default, but some are more likely than others, and it's best to stick to the very highest rated loans.
It can take a long time to put money to work. A week to transfer funds into Prosper, several days to go through the bidding process, and then up to a week to actually originate the loan. You earn no interest until the loan originates. Sometimes a borrower doesn't check out (happened to me once already), so you have to start the process all over. Assume you'll be earning no interest for 2-3 weeks while trying to invest your money.
Standing Orders are your friend. Standing Orders are a mechanism which lets you specify specific lending criteria and an interest rate, and any time a matching loan is available it automatically bids on it. This is handy because it takes the emotion out of bidding, and lets you automatically set criteria which result in an acceptable return for your risk. Too many Prosper.com lenders bid on the emotion, which is why some loans get charged too little interest, and others pay a lot more.
Keep your expectations modest, and you probably won't be disappointed. The majority of Prosper.com lenders with 20 or more loans (i.e. a minimum of $1,000 invested) appear to be earning between 5% and 7% after taking defaults into account. That might not sound spectacular, but it's significantly more interest than a 3-year CD will pay right now. I suspect (but can't prove) that it may be possible to systematically earn 12% to 14% after defaults, by setting up a careful program of Standing Orders which only bid on loans which pay enough interest to more than compensate for the additional risk.
Only bid on loans which expire soon. There's no point in tying up your money for the entire ten days it takes some loans to get bid. Set up your Standing Order to bid on matching loans which end the earliest.
Most borrowers are honest, but borrowers can (and have) lied about anything and everything on their loan descriptions. The only thing which can be trusted is the credit report, since it comes from a neutral third party. Therefore, don't ever bid on a loan because of something the borrower says (though it's OK to not bid because of something the borrower says). Most interest rates get bid too low because something the borrower wrote inspires sympathy, trust, etc....don't get caught in that trap. By the way, this is one reason why Standing Orders are so useful: they're strictly "by the numbers."
As I wrote before, at this stage Prosper.com should be treated like online poker, not a serious investment. Assume you could lose everything, because if the company goes under you just might. On the other hand, if you can afford the loss, it can be entertaining, educational, and sometimes profitable if you're sufficiently disciplined.