Risks of Prosper.com
"Neither a borrower, nor a lender be."
— W. Shakespeare, Hamlet
HT to Money Musings for the highly appropriate quote from Shakespeare.
For those who haven't heard yet, www.prosper.com is a person-to-person lending website that connects borrowers and lenders. Jeff over at pfadvice has a really good introduction to the site here . Right now there are more than 70 people looking to borrow money for a variety of reasons.
It's a really interesting idea, and I'm all for it. The idea is to take banks out of the middle and let people give loans to each other. Borrowers would be able to get better rates and lenders could get a better return for their money. Prosper sits in the middle taking 1% from the Borrower and .5% from the Lender thereby following Shakespeare's advice. All this sounds great...but what are some of the risks to lenders who try this out. I'll be discussing two types of risks that Lenders are exposed to: default risk and prepayment risk.
The easiest risk to understand and tackle is default risk. This is the risk that the Borrower won't pay you back at all. The site makes this pretty easy to handle, first they have a credit grade for the Borrower which corresponds to their credit score. When lending, they give you a historical default probability to help with pricing your loan. You set how comfortable you are lending money to people with a variety of credit scores. They also give you their debt-to-income ratio on a monthly basis. Not only that, but you can diversify by lending to many different borrowers. As a last resort, you can turn to a professional collection agency to help with bad borrowers. All this should help provide adequate measures to help Lenders mitigate default risks.
Prepayment risk however, is much more difficult to mitigate. This is the risk that the Borrower will pay some or all of the loan off early. Why is this a risk? For a couple of reasons. One, it reduces the yield and maturity that you were expecting for the loan. If you lent someone $10,000 @ 9% for three years, you're expecting to make $1447.89 in interest payments over the entire 3 years of the loan. If that person decides to make double the monthly payments every month, you now only make $680.75 in interest payments for 17 months. Now, you're going to have to reinvest those proceeds earlier than you expected. Two, when you do reinvest, you might have to do so in unappealing circumstances, meaning at a lower interest rate for a given level of risk. So in the end, you make less money.
In addition to that type of prepayment, there is also the chance that the Borrower will refinance. Suppose that a Borrower with a 'D' credit grade uses Prosper to consolidate their outstanding high-interest credit cards at 14%. After a year of making payments on time and being wise with their credit, they now have a credit grade of 'B'. They could now refinance their outstanding prosper loan, using prosper again, at 8%. ALternatively, they might even be able to take out a 0% balance transfer. You have now gone from a terrific Borrower who made timely monthly payments at 14% to a terrific Borrower who will make timely payments at 8%, or even not making payments at all. On top of that now that they're in a better credit grade, there will be more Lenders (potentially) vying for their loan and pushing the interest rate lower. That leaves you making less than the 16% you anticipated.
Plus I would argue that right now prosper is not very efficient. You can get great rates on pretty high quality Borrowers. Once more people are involved, it could puch rates lower and make it less profitable for Lenders. This could also affect prepayments/refinancing because previous Borrowers will be aware that rates have gone down and will refinance in the ensuing competitive environment.
Quantifying prepayment risk can be done, but with a lack of data on prosper Borrowers, that will remain a difficult risk to quantify for some time.
These are the two main risks (financially speaking) that I forsee with prosper.com. I would add that other risks on the horizon are potential security risks from identity thefts. Extension risk, the risk that what was once a three year loan now becomes a 5 year loan. Not sure if that would be possible in the current state of the site. Another risk is whether there will be enough Borrowers to provide adequate diversification for Lenders.
It's an interesting idea that I'll be watching for potential investment opportunities. What are people's thoughts on any other risks that I've missed?
9:21 AM
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16 comments:
Great review. I agree with the fact that once more and more people begin to join it will push the interest rates down. Who wants to accept a 3 year loan at 5% when current money market rates will be approaching that amount in less than 3 years assuming that the fed keeps continuing the rate increase.
Good write-up.
Yeah, lenders will have to tread carefullly. Risk is risk, and it's out there pretty much everywhere.
The question becomes: What's your tolerance?
FSA,
A good analysis. I had thought about the risk of prepayment but hadn't thought it through as well as you have. To your analysis I would add that 3 year CD rates are still hovering around 5 percent, so I wouldn't undertake a Prosper loan for under, say, 6 percent. Not worth it, even with a low-risk borrower.
Also, Savvy Saver points out that they do nothing to check on your reported income level, so you should take the debt-to-income ratios with a grain of salt.
Good comment on Prosper, but I dont understand how a father of two (or three) could watch his children being born and still be an atheist. I'm not a hater, though.
I just posted a 6-month review of Prosper.com and cited this article. If you're interested please check it out!
Go to article on InvestorGeeks.com
Ok, I understand why you call out the risk of prepayment, but is that truly a risk? You state (rightly) that: If you lent someone $10,000 @ 9% for three years, you're expecting to make $1447.89 in interest payments over the entire 3 years of the loan. If that person decides to make double the monthly payments every month, you now only make $680.75 in interest payments for 17 months. Now, you're going to have to reinvest those proceeds earlier than you expected. True enough. I ask, so what? Your statement that you may end up with a lower return on those monies in the future is true, but you may end up with a higher return as well. Prosper allows for automatic re-investment of your funds based on user-entered criteria, so your money can continue to work the way you want it to without intervention from you. Arguably, pre-payment could as easily be seen as a good thing as a risk.
It's a risk in that it entails some level of uncertainty. It could be bad or good, you don't necessarilly know.
People are more likely to prepay when rates have gone down; i.e. when it's unfavorable to the lender.
Yes, I feel so sorry for a lender who only gets 600 instead of 1200 dollars off a loan. After all, you had to work so hard for that 1200 dollars! Oh, no, wait, no you didnt.
Prosper is about helping people, not about greedy bastards making a living off of others labor. Thats why its supposedly better than banks.
Of course, maybe it isn't, and maybe we will see in the long run its not really about helping people. But the theory is completely the opposite of what your take on it is.
If prosper were about helping people then it would be a charity site. Prosper is a tool for people to get loans they otherwise might not have gotten, or for people to make money off those people. Period.
Actually, Prosper only allows you to take out one loan at a time. Obviously, if you collude with a spouse or friend, you can get around that rule though.
The smartest way to approach lending on Prosper as an investor/wealth builder, is to make absolutely certain that your money is always working for you. It does not matter if someone doubles their payments and pays it off early. It is about putting every penny in interest earned back to work. It would be fine to have it repaid fast or not either way works. Regardless, this isn't about placing a bet that hopefully the borrower will pay me back, even though I hope that they will. It is about helping people as pointed out. But, more importantly, I have seen lenders bid out 1000s of dollars on a single D, E, or HR rated loan. That is not wise money management. At all. A good calculated risk strategy across credit grades you are comfortable with, at small amounts will produce good yields. Anyone who understands the math will tell you the same thing. Not to mention it is obvious. I have reasonable expectations for a return and I expect to lose a few loans, but I do not want to lose out on this opportunity. I am proud to be a lender and am working on a lending group, Aimvest prosper loans - visit our site if you want to learn more about us. These are quality posts. Prosper folks are pretty passionate either way.
For another viewpoint on Prosper read the August entry under redtoblack on networthiq.com .
The biggest risk to me with pre-payment is the time it takes to re-invest the profits. It can easily take three weeks to invest money in prosper. All this time, it is sitting there without interest. A quick estimate on my ~200 loans is that this reduces your overall return by ~1%. That's a pretty big hit. I'm sure some may question the three week timeline. But if you include the time for bidding, outbidding, rebidding, loan rejection, rebidding, etc, etc, this is rather typical. Similarly, a significant issue with prepayment in traditional loans is all of the initial transaction costs. I believe this is also why you haven't seen big lender money go to work at propser. With 80 Million in loans, a handful of investors could simply crush the whole system and drive down rates (I'm not one of those handful). The interest rates are attractive, but you can't simply put down a lot of money and invest it today and put it to work immediately.
I am a prosper lender and I have a question regarding the sub-prime mortgage crisis. What effect do you think this will have on the default rates for prosper borrowers? What advice can you give me?
Thanks
prosper is a great site if you worry about prepayment and people not paying back there loans then just bid 50 on each loan so far 70 loans 17k in there the only big one i have is my little brother that i funded for 5k my bids go from 50-500 some lager if i take the time to look the person up i am biding on...probly the thing that sucks is you check out someone and sounds good bid and lose last min to some neb on the site i get the rate i want i try not to bid lower than that..last words stay away from hr and e rated borrower...only last thing stop giveing the AA borrower rates at 7% or lower i will no longer bid on those ones now 10-13% is my min i am sure i miss out on some good loans but there will allways be more thanks wisconsin_lender2007
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