Disclaimer: I have been a prosper lender since July 2006. I have had close to $10000 invested in prosper and at one point I was in the top 1000 lenders in terms of portfolio sizes. However, I have stopped lending money on prosper. If there was a way to sell loans, I would do so but there isn’t so currently I am just pulling my money out as it becomes available. The rest of this blog entry details my personal opinions and experiences with peer to peer-lending. I advice you to do your own due diligence!
I got caught by the bug of lending money to people a little less than one and a half years ago. On the top of my head I could think of several reasons of why peer to peer-lending seemed superior to other passive income generating investments.
- First of course was the higher interest rates. I figured that if I could get an interest rate of 10% plus the experian default rate and choose my borrowers wisely, I could eke out a slightly higher return. Thus if I sold off some stock positions, I could throw $40000 into prosper, which would result in monthly income of 40000*0.12/12 = $400/month. Sweet!
- I would get to help borrowers directly.
- Borrowers in turn would be more responsible about paying back my money. I figured borrowers would be less apt cheat regular folks out of their money compared to credit card companies.
- By cutting out the middle man, administration costs would go down.
It turned out later that these assumptions are not entirely justified.
Still I retained a bit of skepticism. Basically my strategy was not to lend more than $50 except under exceptional circumstances and then no more than $100. Not lend to anyone with current delinquencies. To stay away from high risk and no credit borrowers and people with crazy loan requests. And finally always to get 10% above the experian default rate.
I thus entered slowly building up my position over about half a year. At the time I also read articles about people who have put all their retirement savings into prosper and was taking out hundreds of dollars of interest a day. Greed is good?
Everything went great for the first several months as I was building up to over 200 loans. Then I got a few late payments. Then a few more and soon I had my first 3+ month late loan. Things still looked pretty bright though. At that point I expected that the loan would be sold off. Of course however, this is not the case if there are no buyers. Some of these late prosper loans can linger for many months and until they are charged off, you can’t even claim them as capital loss on your tax return. Meanwhile, interest income keeps accruing. I hope this will change someday.
About a year after I started, late loans became a way of life and the merciless consequences of statistics began to factor in. I also began to notice patterns. People would get a loan, make one payment, and then stop. Others would make 3-5 payments and then stop. I suspect the first kind was just out to sucker the lenders and made one payment to have a plausible excuse of good intentions. The second kind would probably default in the time it took them to burn through their loan ignoring their stated intent to get out of debt.
I should say that maybe about “only” 10% of my portfolio has or is expected to default so far. Most borrowers are good people. It is the remaining 10% that ruins it for everyone else and causes the high interest rates. It is not uncommon for someone to borrow the maximum amount of $25000 and then declare bankruptcy a couple of months later. Words describing my opinion of these people are not fit for print!
For me prosper has been a valuable and not too expensive learning experience on the financial habits of my fellow human beings. Some of the things people want to borrow money for are just outright crazy. I also found it interesting that it is very difficult to predict who will break or keep their promises. I now understand why credit card companies and payday loan companies charge exorbitantly high interest rates. It is not to screw people over. It is to cover their default rates and the high interest rate should basically be thought of as an insurance premium rather than a profit. If there was a better way to weed out the bad borrowers, the rest of us could enjoy loans at the prime rate.
However, as far as I know the credit card companies have not come up with anything better than credit scores. The question then becomes whether a peer to peer-lender can come up with something better. Some group leaders have personally vetted all their loans rather than just relying on stated income, etc. I believe this work is worth something and will be rewarded. For those of us that just go by the numbers e.g. set up “screens” like we would screen stocks for P/B, P/E or PEG values, we should probably expect to come in just under the bank return of investment rate. The reason is that we as peer to peer lenders are dealing mostly with borrowers that the banks would not touch and we are not adding much value to the process by merely running a few screens.
Still some lenders are obviously doing great and counting no defaults. Now they may be exceptionally good at judging borrowers, but I suspect that a bigger reason is because they have few loans (maybe 50 or less), a shorter lending history, and that they have simply been lucky so far. Small concentrated portfolios come with higher volatilities, so for those who have only invested a couple of thousand on prosper and is seeing 15% returns, it may be a question of luck rather than genius. peer to peer lending is no different here than a concentrated stock portfolio. In particular those who invested in high risk loans AND were lucky would see very high returns or whereas those who have been unlucky see very negative returns.
Peer to per lending adds to diversification. The question is how much diversification it adds compared owning shares in the financial sector that does consumer lending already. Clearly diversification within a sector does not help much when the entire sector is ailing (as we saw the the CDOs). Of course with prosper one gets the entire human factor and bidding on loans can be addictive like eBay auctions which of course is fun for all the wrong reasons and thus should be discouraged. I note however that the human factor does not seem to be much different for peer to peer loans. Stranger to stranger loans seems to be more descriptive of the arrangement.
Personally I am getting returns from lendingstats around 8-8.5%. This is no better than the return on closed-end high yield income funds. The latter comes with the added benefit of being easily sold or bought whereas prosper loans are locked in for three years with little control. Since I mainly invest for returns rather than the charitable aspects, I prefer tradable and preferably senior issues for my fixed income needs unless the returns outweigh the risk of uncollateralized loans. This has not been the case for my prosper venture and since I do not know how to fix it, I am liquidating my position.
