Prosper Update 2

This is the third in a series of post's I'm doing on Prosper, the peer to peer lender.

See Part 1
See Part 2

See Part 4
See Part 5

Today my money transfer went through. Prosper was kind enough to send me an email reminding me that money sitting idle is not earning interest, and I really should invest in some loans. Point noted. I'm excited to see how setting up a portfolio on Prosper differs from Lending Club.

My first option is the choice of plan I want to create. Since I don't have time to sit around bidding on loans all day, I'm going to setup an automatic plan, much like auto bidding on Ebay. I really appreciate how Prosper lays all the information out. They give you an estimated return for each of their automatic plans, and break it down by average loan interest rate, minus losses due to defaults and service fees based on Prosper historical data.

Many people who consider investing in loans are scared off because the borrower might not pay the money back. If they are unlucky in their choice of borrowers, they fear losing a lot of their principle.  Hopefully this historical breakdown will allay some of their fears. The more diversified your loan portfolio is, the more likely you will have a person default, but you will be less likely to be hurt significantly by the default. Having more loans will bring you closer to historical models of loan defaults, and you will be better able to quantify the risk of default. There is protection from the individual risk of a loan default by investing in more loans, just like there is protection from individual companies going bankrupt by investing in a broad market mutual fund. This is where interest rates make a difference. If you invest in higher risk loans, a higher interest rate is needed to make up for the higher number of defaults. Some loans will defiantly go bad, but the ones that do make it to full repayment will make up for those losses.

This is also where Prosper fails the lender and helps the borrower. Because interest rates are "bid" for, the final interest rate may not reflect the real risk associated with any particular loan. For lenders, if many loans in your portfolio are like this, when defaults occur you will not be adequately compensated by other loans in your portfolio and your returns will be below expected and possibly negative. For the borrowers, this means they  may get a loan more cheaply than a conventional institution would ever consider allowing.

I decided to make my own custom plan. Interestingly enough, after adjusting all the criteria to suit my preferences, Prosper estimates that my real return will be somewhere around 7%. I think I'll do better, but only time will tell. My main customizations where to limit the Debt to income ratio < 20% [prospers maximum is 40%]. With fear of recession abounding, there needs to be room for people's budget stay flexible. The bigger the DTI ratio is, the less flexibility a borrower has in their spending, and I bet loans will default before people give up their home or food or car. Another thing I don't like about Proper is the $50 minimum bid. Lending Clubs had a $25 minimum, which means you could get 20 loans for $500 vs 10 loans on Prosper. As noted above, the more loans you have, the more quantifiable your risk is. Starting out with 10 loans leaves more room for bad  luck than a larger sample of loans. I expect my loans will grow as I invest more. Another scary thing is the lack of review. With the automatic plan, bids are made for me and can't be undone, only out bid. I have a predilection for people who are getting out of credit card debt, but I don't think that is a criteria I can select. Oh well, I'll just have to see what my plan turns up.

Comments

[evelyn]

be careful with portfolio bidding. it is always best to use q&a with borrowers to learn more than the numbers about their situations.

[Step3]

Thanks for your insight Evelyn. I have used Q&A before, but I'm not heavily dependent on it for a few reasons. First, if the borrower is scamming you, or just trying to improve their chances of getting a loan, they maybe less than honest. Second, I don't have time to follow up on Q&A when loans are only funded for 7 days. Third, I don't really have time to follow the bidding or evaluate the risk associated with each loan and decide what interest rate would be unacceptable for me to bid. I do intend to explore placing individual bids some more, but for the moment auto bidding fits my needs.