Suggested Lender formula for pricing prosper loans.
please see the refined formula: here
default rates taken from prosper:
AA .20%
A .90%
B 1.80%
C 3.30%
D 6.20%
E 11.10%
HR 19.10%
I would like to recommend a formuala for how to price a loan on prosper.com from the lenders perspective. Here is my suggested FSA Prosper Formula (patent pending j/k):
AA .20%
A .90%
B 1.80%
C 3.30%
D 6.20%
E 11.10%
HR 19.10%
I would like to recommend a formuala for how to price a loan on prosper.com from the lenders perspective. Here is my suggested FSA Prosper Formula (patent pending j/k):
The variables:
- R (prosper): this is the total rate to bid on the loan
- R (risk-free): this is the risk-free rate, or basically what would either a high yielding bank or money market account give you for your money
- R (default): the expected rate of default on the credit grade
- R (prosper-fee): prosper currently charges .50% as a servicing fee.
- R (excess): this encapsulates your profit margin and other risk factors such as prepayments
Example:
B grade borrower wants to borrow $5000. DTI is fairly low, wants to use the loan as a consolidation loan for high-interest credit cards. Taking my formula I would be comfortable bidding the following rates:
R (risk-free): 4.25% (This is my emigrant direct savings account)
R (default): 1.80% (according to prosper, a B grade borrower defaults 1.8% of the time)
R (prosper-fee): .50% (current servicing fee from prosper)
R (excess): 1%-5% (this is the profit I want to make, prepayment risk, other perceived riskiness of the borrower, anything else I could use to make my determination)
that gives me a total of: 7.55%-11.55%.
So if the max rate the potential Borrower allows is only 5.75%, then per my formula above, I wouldn't want to bid on that loan. As you can see, the most subjective area is that R (excess). This allows for some wiggle room, but also allows for someone to build a model that might take into account DTI ratio or something like that to refine the formula. Use it as a starting point.
Also, here is a good post from a Borrower's perspective.
Tags: personal finance prosper
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5 comments:
Very interesting stuff. I'm currently raising some money on Prosper, and have had it fully funded for about a 5 or 6 days now, with the auction ending tomorrow. I seriously think this is a great site that could grow into the next eBay.
Franky,
Thanks for the formula. I now use it as a guide for minimum funding of loans.
The adjustment that you should make to account for the default risk is more complicated that your formula suggests. To transform an Expected yield (ie, one that is equivalent to a 0 risk rate) into the equivalent "Promised" rate for a loan with default risk the correct formula is
Promised Yield = (1 + Expected Yield) / (1 - Default Rate)
Another thing to consider is the risk free rate you use in your formula. I would argue it is too low. You are tying part of your principal up for upto 3 years on Prosper and you should demand a higher rate than an "overnight" rate like your Emigrant Direct account. I use the 2-year T-bill rate (currently 4.89%) myself. (2 not 3 years, by the way, because 3 years is too long since part of the principal is returned every month. If they posted an 18 month rate I would use that)
Personally, I also add a small "call premium" since Prosper loans are callable by then borrower (ie they can pay you back when they want). It may seem trivial but in the event that rates go down, borrowers can cancel the loan early and you won't get the benefit of the high rate. However, if rates go up, you dont have the same privalege and are stuck with a low rate. You should demand compensation for this "interest rate risk". I use 0.5%, which is standard in the corporate world for callable bonds. I dont know of a consumer equivalent or I would use that
Shouldn't that be:
Promised Yield = (1 + Expected Yield) * (1 - Default Rate)
the other key variable is hwo much you can expect to receive should the loan go into default and the collections.
Anonymous's first formula is right with respect to calculating expected returns, but he is a bit too conservative in that he assumes in a default that you get nothing,.
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