Investing In Peer-To-Peer Lending With Prosper.com
With savings interest rates under 0.3%, the 10-year yield under 2%, and stock market dividend yields under 2.5%, investors are starving for yield. I’m looking for a relatively hands off investment class that can provide superior yields as my long term 4%+ CDs start rolling off in 2014. I think I’ve found it in peer-to-peer lending with Prosper.com. Many of you have asked about P2P lending forever and I’m pleased to embark on this new income stream.
I’ve known about San Francisco based Prosper for years, but I’ve never bothered to invest because the industry was still defining its own rules. P2P lenders sprang up in 2005 to provide needy borrowers with viable alternatives to normal commercial bank loans. The idea was to reduce borrowing costs by removing the bank intermediary, and utilize the internet to connect lenders and borrowers to make more and save more.
The concept is good, but default rates prior to 2008 were commonly as high as 20% vs. 1-5% default rates for traditional commercial bank loans. In response to higher default rates and a determination that P2P investing is a security asset class, The Securities And Exchange Commission (SEC) put stringent regulator oversight on the industry and forced P2P lenders to be more vigilant in screening their borrowers based on their credit histories and submitted information. Also, if a borrower’s loan becomes delinquent, P2P lenders will appoint a collection agency.
PEER-TO-PEER LENDING IS SAFER NOW
With regulatory oversight and now seven years of operating experience, I’m finally dipping my feet in the water. The advertised blended rate on Prosper.com is 10% and there have been no total blended losses for Prosper investors since 2009 who have at least 100 funded loans. 10% is currently over 5X the 10-year yield, which is also called the risk free rate. With my 3X risk-free rate bogie equaling 5%-6%, 10% is a very attractive proposition. The fact that Prosper investors showed positive returns even during the financial crisis is also very appealing.
Before investing in any asset class, I like to spend a lot of time doing my due diligence. Prosper.com is based right here in San Francisco, so I went and sat down with them twice for over one hour each time to learn more. I was comforted by the fact I could shake someone’s hand in person and speak about the pros and cons of P2P lending. Here are some of the pros and cons I’ve learned.
Benefits For Lenders / Investors Of P2P Lending
- Higher rates of return adjusted for risk.
- The ability to screen applicants and individually choose particular borrowers.
- Once you develop a good sense of the type of borrowers that suits your investment profile, you can continue to find similar type borrowers given Prosper’s marketplace is so huge.
- There are literally thousands of borrowers with various ratings you can choose from to tailor your desired returns. The higher the risk, the higher the returns and vice versa.
- If a borrower ever wants to borrow again on Prosper.com, they need to honor their loan. The Prosper marketplace theoretically reduces default risk over the long term for investors. The idea is similar to one’s social capital online. You don’t want to have many bad reviews or else nobody will ever want to deal with you!
- Prosper will hire a collection agency to help you get the non-payer to fulfill their loan obligation.
- Regulated by the SEC.
Benefits For Borrowers Of P2P Lending
- Access to money and credit without having to go to the bank or go through loan shark companies.
- Easy to use online platform walks you through step by step when filling out your application.
- Entire process is easier to go through, with less documentation required than traditional loans in most cases.
- You can explain why you have bad credit and sell your story to investors. Banks are now super stringent and are unwilling to lend to anybody with poor credit. In a time when so many people have foreclosed on their homes, this is a big problem for potential borrowers.
- If the borrower creates a second listing, after having 6-9 months of no missed payments, Prosper shows their exact payback history with them during that time. This is only seen if the borrower creates another listing though. In other words, borrowers can build their borrowing reputation to keep coming back for more.
- Loans through prosper are unsecured, meaning borrowers don’t have to come up with collateral such as a house or car to get a lone.
- You can practically use your loan for anything.
- Regulated by the SEC.
P2P RISKS EVERYBODY SHOULD BE AWARE OF
Every investment carries risks. Let’s discuss the risks for investors and borrowers.
- You might lose money because you are not diversified enough. Diversification will be one of the main topics I will write about on Financial Samurai. Another main topic will be to discuss investment strategies to maximize returns.
- Your P2P lender could conceivably go out of business, leaving you as a creditor. I’ve been told by Prosper that they have entered into a back-up servicing agreement with a loan servicing company that is willing and able to transition servicing responsibilities in the event they can no longer do so. The third party is a financial services company that has extensive experience and knowledge entering into successor loan servicing agreements. Prosper also has an “Indenture Trustee” named Wells Fargo that grants note holders certain rights and protections.
- Prosper notes are not FDIC insured up to $250,000 for individuals or $500,000 for couples. Leaving your money in CD’s and savings isn’t sexy, but at least if the bank goes under, the federal government will give you your money back.
- In California, you need to make $85,000 a year or more to lend.
- Rates increase with the length of your loan. The reason is the investor demands a higher interest rate for a lower monthly repayment and a higher chance you decide not to repay over time.
- You are generally restricted to “only” $25,000 so if you are looking for more than that you will need to seek out some other sources. The reason for the $25,000 restriction is to mitigate risk to the lender. Imagine if everybody was able to borrow $1 million dollars. The likelihood of borrowers fleeing the country increases!
- If you are self-employed or do not have any W2 income, getting funding will be more difficult. Banks will shut you out of a loan and from refinancing, but at least Prosper gives you a chance to tell your story.
Borrowers: If you are interested in becoming a borrower at starting rates as low as 6.59%, you can sign up here. It’s better to borrow at 6.5%-10% than pay 20%+ on your credit cards! Debt consolidation is the absolute best reason to borrow through P2P lending.
MY GOALS FOR PEER TO PEER LENDING
I chose Prosper.com because they were the first company in America to launch peer to peer lending in February, 2006. I’ve met with representatives twice in person and plan to have a continued direct dialogue with them as I go on my P2P lending adventure. I’m also lucky to be based just a couple miles away from Prosper’s office to meet up on occasion. They have over 1.3 million members with $364+ million in funded loans.
Here’s what I hope to achieve with Prosper long-term:
* Diversify my revenue streams and create sustainable passive income.
* Find savings and CD investment alternatives given I think we’ll be in a low interest rate environment for a long time.
* Specifically boost my passive income by another $500 to $1,000 a month by investing $50,000 or greater in P2P lending over the next several years. Ideally, I would like to have the confidence to invest over $250,000 in P2P and try and make $25,000 a year in passive income.
* Continue to build my online income by providing a portfolio of P2P lending related articles where readers can follow my journey, participate, and learn.
* Become an expert in P2P lending because I think the industry is going to continue to grow with so many success stories of positive returns.
Investors: If you would like to join me in building wealth as an investor through Prosper you can sign up here. I plan to invest in Prosper for as long as the returns are over 3X the 10-year yield = 6-8% returns which is far better than any CD or money market account.
Note: Prosper allows investors in the following 29 states: Alaska, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Louisiana, Maine, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New York, Oregon, Rhode Island, South Carolina, South Dakota, Utah, Virginia, Washington, Wisconsin and Wyoming.
About the Author: Sam began investing his own money ever since he first opened a Charles Schwab brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college on Wall Street. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 35 largely due to his investments that now generate over six figures a year in passive income. Sam now spends his time playing tennis, spending time with family, and writing online to help others achieve financial freedom.
Best,
Sam
This is definitely something I have been considering but I need to do a bit more research first. The thought of these companies going bankrupt is a big fear but they seem more established every year that goes by.
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I have thought about investing with companies such as Prosper. Like you, I am still a little skeptical about people defaulting and leaving me holding the bag. I think I will try it soon though and just take the risk. Thats the point of investing, right? Thanks for providing more info on the pros and cons of P2P lending.
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I use Lending Club. I have done it for about 3 years now. I only have a few thousand dollars in it but it’s fun for me. I always invest the minimum and spread out my loans to as many debtors as I can (over 100 loans). $25 each loan. I have a return of 10.27%. It’s fun to help people out and it’s personal as you see what they need it for. It’s also nice to get a good ROR although I’m killing it trading options right now so it’s not the best choice for me right now. Good for a possible income stream though! Maybe put enough in there to cover a car payment or something! Have fun!
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Thomas Reply:
November 7th, 2012 at 10:32 am
Dan, could you elaborate on your option trading? Used to do it, but kinda got out of it when everything hit the fan.
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I’m glad you’ve chosen to take this foray Sam. I have been thinking about branching out into P2P lending to diversify as well, but have been concentrating my capital to my dividend earners portfolio. Thankfully, down the road when I’m ready to take the plunge, I’ll have your experience to read up on and absorb.
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Those are some nice looking returns on the investment side. I only first heard about P2P one or two years ago and I like that there are regulations that protect investors. I’d much rather lend someone money through a platform like Prosper that has protection and high returns than lend money to friends or family when theres never a gurantee of getting money back, no protection, and typically 0 earnings! I’ve learned the hard way to avoid lending money to family members. That’s cool you got to meet some people who work for Prosper too.
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Sucker punch Reply:
November 3rd, 2012 at 5:05 pm
Lending money through Prosper doesn’t offer any more of a guarantee that you’ll get your money back then lending to people you know. I don’t mean to discourage anyone from investing at Prosper, just make sure you understand what you’re getting into. I’ve been using Lending Club (similar to Prosper) for about three months. I use the same tactic there that I do when lending money to friends, which is: don’t lend anything out that you can’t afford to not get back.
(of course, when you lend through Prosper you don’t have to see pictures on Facebook of a friend who owes you money treating his family to a Disneyland vacation. Ouch!)
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Financial Samurai Reply:
November 3rd, 2012 at 5:19 pm
I think it does because a borrower needs to go through a credit check and application process. Once through, the borrower has to fill out a profile and explain what they need the money for.
For friend or relative, there is not as much effort to ask for money, which makes not paying the money back easier.
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Thanks for the rundown. I am an investor at Prosper for about a year now. The default rate is just starting to hit its stride. It’s a bit disconcerting to see the loans defaulting. I’m planning to start investing at Lending Club to give them a fair shake. They have one advantage. You can sell your loans when it is late. At Prosper, you can sell your loans as long as it’s not late. That’s a big difference.
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I have been investing in loans at Prosper since 2007. I notice a lot of high net worth individuals who put a lot of money into Prosper lost their shirts. One famous user, Pensioner, put in about a million dollars and lost quite a bit of his portfolio, mainly because he was a champion of non-diversification – which bit him in the butt.
My loans have been more conservative, but I have noticed that a large ratio of borrowers that defaulted were in the A credit rating. This is more so than the C or lower categories which is strange. Most recently, I have created a more strict search option and decreased my investments to only about $1000.
I believe the quality of applicants have decreased over time and they are asking for large amounts that they cannot possibly sustain payments for with their current level of income. Wade carefully.
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I have invested in 11 notes through Prosper starting in 2007.
In November 2009 I had my first loan default. The loan originated in April 2008 for $87.10 and they only paid $46.87 of that amount.
In August 2011 I had my second loan default. The loan amount was for $50.00 and the borrower never paid a penny. The first payment defaulted and several months later the full $50.00 was charged off. Oops.
The April 2008 loan was rated “B” and the August 2011 note was rated “E.” Please note that April 2008 was before the regulatory changes that took place in 2009.
For the other 9 loans, 7 of them have been paid off in full. The other two are in good standing and are scheduled to mature in 2013/2014. My diversification through borrower ratings was: 1 AA, 5 Bs, 1 C, 1 D, 3 Es.
My annualized return has been 4.59% + 0.36% (Prosper promotions) = 4.95% total annual return
Having that $50.00 loan go into collections before even one payment was collected was rather disappointing. But, I know I was pushing my luck with loaning to an “E” borrower. Luckily my other two E borrowers have been making good payments. One paid off early and the other is scheduled to finish his payoff in July 2013. He has already paid $56.16 of the $49.06 I loaned.
I know this is just a tiny sampling of data, but I figured I would share my experience with Prosper.
FYI, the WSJ had an article back in April titled “Would You Lend Money to These People?” It made for a pretty interesting read.
Good luck with your P2P lending.
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Financial Samurai Reply:
November 2nd, 2012 at 8:59 am
Excellent insights. 5% annualize return isn’t bad at all, especially if you didn’t lose money when EVERYBODY lost money in 2008-2010.
I will be writing A LOT about who I plan to lend to, and who I don’t plan to lend to.
Having a blog and investing in P2P really lends itself to some great discussions and learning experiences!
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Nice summary of P2P lending. I started testing the waters a few months ago with Lending Club & i’ll be interested to follow along with your experience with Prosper.
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I’ve been using Propser since 2005 and have been happy with my experience. I have stuck to high-grade notes, and have had a 5.85% annualized return over the last 7 years with Prosper. I’ve had about a dozen noted default during that time, but I keep my loan amounts to $25 to minimize damage to the entire portfolio. Funny thing is, I’ve actually had people default on notes even after the initial loan amount was repaid.
The great thing about lending is that you are repaid both principal and interest each month, so you initially lend $25, but you get $25 back before the note is due, and can re-invest into another loan. For example, I only invested $500 7 years ago, but I currently have invested or re-invested roughly $2,800 over the same period.
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Sam, An excellent first article on Prosper and p2p lending. I appreciate the due diligence you did, far more than the average blogger who writes these kinds of articles. Just one point of clarification for your readers about the SEC regulation. It had nothing to do with the 20% default rates. Lending Club were the first to go through SEC registration and their default rates were actually quite low. The SEC simply decided that this kind of investment was a security and not a direct investment from lender to borrower.
Great to see another blogger going in depth on p2p lending. Look forward to your future articles.
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You raise a good point about survivorship bias and improving loan quality over time. I hadn’t considered that people might turn to Prosper twice, so repaying the first loan is a necessary requirement to using it again and again. Theoretically, loan quality should only get better.
I find a 3 year amortizing loan with Prosper’s rates to be very enticing as the weighted average life of the loan is a bit shorter than 3 years when you compare it to bullet streams like CDs. The spread between Prosper and CDs is even higher when you consider the effect of compounding.
From memory, I’m pretty sure Prosper does not fund its own loans and Lending Club does. If I had to pick, I’d definitely go to Prosper over Lending Club just for that reason – not fair for Lending Club to have informational advantages over their members who invest in the company’s loans. There isn’t much of a choice for me though – I live in the wrong state!
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Financial Samurai Reply:
November 2nd, 2012 at 8:58 am
That’s the thing… online social capital is really becoming important b/c there is a history of everything we do.
If the borrower creates a second listing, after having 6-9 months of no missed payments, Prosper shows their exact payback history with them during that time. This is only seen if the borrower creates another listing though. In other words, borrowers can build their borrowing reputation to keep coming back for more.
Care to elaborate on not fair LC funding their own loans and not being fair? Wouldn’t it be in the best interest of LC to have the best loans for all?
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JT Reply:
November 3rd, 2012 at 2:43 pm
It’s in the best interest of LC, but not necessarily LC members. P2P is unique in that it is mostly individual investors, not instutional money. What makes LC different from any old bank if it just funds the requests as they come in? LC definitely has way more information about its borrowers than any individual ever would.
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Al Reply:
November 3rd, 2012 at 9:42 pm
Uh, I’m pretty sure Lending Club doesn’t fund loans with their own money. They have funds set up where investors can send their money, but so does Prosper.
Why not invest with both?
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Sam, good article. Just curious, why did you pick Prosper instead of Lending Club?
We have been investing on both Lending Club and Prosper and very happy with the returns. We like LC better because of volume of loans and also restrictions on LC Advisor and institutions that allow us to invest along side them in most loans.
I have been extensively analyzing LC historical data on my blog Random Thoughts at andirog.blogspot.com. Defaults appear to be of little impact on return based on the data available since 2007 as long as lender spreads investment across lot of loans. LC claims no one had negative return who invested in 800+ loans. Also, imo LC has done good job assigning credit grade and interest rate based on risk.
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I just started with Prosper a few months ago to test the waters and found that usually having many notes from A to C works best if I only invest 25-50$. CD rates at the moment just stuck in my opinion and this gives me another option. I do feel that there is a place in my portfolio for CD’s so I use them but want a little better rates so I add Prosper to the mix.
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@Debt and the Girl I was skeptical for the first several years, but after 7 years of operation and knowing so many friends who invested and DIDN’T lose money in the 2008-2010 downturn, it’s time. Interest rates are too low for CDs and savings.
@Dan Good to hear you’ve got some good 3-year history! When is it time to put some more money in?
@Michael No prob Michael. I’ll probably write at least 10 posts a year on the subject, with various thoughts, strategies, moral issues, etc. Will be a good learning experience!
@Untemplater Ah yes, lending to family members who will likely never pay you back is a different subject matter altogether!
@retirebyforty Yeah, I’m already expecting the default rates. Part of the business. I’ll let me writing be a release when some of my borrowers don’t honor their commitments!
@The College Investor 5.85% is great! You are one of the early ones. When you gonna to invest more in?
@Long Well, I definitely plan to invest in at least 100 notes so I’m diversified. P2P lending is my diversification of my income streams, and I want it to work for me. My bogie is 6%.
@Peter Renton Good to know Peter. I’m sure there was something to do with the huge default rates prior to 2008, because that’s all I read about then. The articles are still around in the web. Oversight rises out of complaints and lots of interest!
@Thomas S. Moore Makes sense. I’m probably going to go the dumbell approach and go both ends.
@Anil @ PeerCube Better platform, better relationships.
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It is still not available in many states :(
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I just jumped into P2P investing a couple of weeks ago – but at Lending Club instead. I’ve got a post started (not finished or published yet) similar to this one, but I wasn’t able to do near as much detailed and in-depth research as you Sam. Thank You for this as it provided good confirmation for me that I made the right choice in jumping into this investment vehicle.
One thing I can say for those who live in states where this type of investing isn’t allowed or available. I live in MI and I could NOT invest at Lending Club in the traditional sense – but I am allowed to participate in the note-trading platform. Basically, this is just a place where you can buy and sell notes that are already funded. I haven’t taken the time to check into it, but is this something that is available at Prosper?
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Sam, I opened both Prosper and Lending Club accounts a couple of years ago when they had promotions for free money just for signing up. I figured why not play with their money instead of mine?
After earning a 15% return, I decided to add my own money. I spread it around in $25 chunks like some of the other commenters and have never had a default on my Prosper account.
Unfortunately, I did have a loan default with Lending Club and because the investment account is so low I have negative returns. I’ll put some more money in this account soon to compare my experiences and decide which is better for me overall.
After fully funding my 401K and IRA, this was a good option for me to continue saving while doing good for other people.
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This is a very interesting lending service from both sides (investor and borrower). I have never checked it out, but obviously the fear here is default. It sounds like that happens from time to time. I have you looked into a form of insurance to cover default? I wonder if something like that is out there…
Anyhow, very interesting. I look forward to hearing more about your experience with Prosper.
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Where on the spectrum of risk would you put p2p lending? Is it between stock market and bonds? Or more risky than the stock market? I guess it depends on the person you are loaning the money to.
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I think these principles would work also on LC as well. But it’s good to get the advice before I start investing in something like that! It would suck to not be informed enough before I get involved with the process of lending money.
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Prosper & Lending Club have been great pioneers in the peer-to-peer lending space. I’m the community manager at SoFi, and we’re taking this model to the next level with alumni community-based student loans. For more info, checkout http://www.sofi.com. I think you’ll find what we’re doing to be really interesting!
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Hey Financial Samurai,
I recently started following you and the information you provide on this site has been very helpful! Brief history about me – I quit my job in a Fortune 200 financial services company because I just couldn’t stand it anymore! I am married with 3 kids, my dear husband continues to work for his company and provide the funds needed for our basic finances.
Since I have started my entrepreneurial journey (one project in the works to be released next quarter), I have become more conscious of spending and of managing our money better. Although I am by no means a multimillionaire like you, we do have quite a bit saved in our 401K, children’s college savings accounts and other savings. I like your viewpoint on diversification and the sources you outline for passive income. In my experience very few people who work in the corporate world give much thought to how they are are diversifying their savings and investments. They are content with maximizing their 401K, and participating in the stock purchase plan and maybe investing in a 529 plan. I completely agree that P2P lending is booming and now is the time to invest. I recently opened an account with the Lending Club and after reading your post also opened one at Prosper. For now I am being cautious and investing < $12000 total in both accounts. But overtime I may choose to move more funds in. My kids college funds are returning less that 4% (Treasury accounts) and I am looking for ways to bump that return up.
Thanks for bringing us awesome useful content!
Kay
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Samurai Sam,
Nice article. I have been investing with prosper since mid 2010 and have a 14.6% ROI. I had no real criteria other than gut. I have stopped investing for about a year but want to jump back in. If you are willing, would you share the criteria you are using to filter loans? I would be interested to see yours to get some ideas.
Thanks
J
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Financial Samurai Reply:
December 28th, 2012 at 11:20 am
Hi J,
Here’s one of my foundations for investing in new loans: http://www.financialsamurai.com/2012/12/07/p2p-investor-returns-by-borrower-rating-and-credit-score/
Thx, Sam
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Tek Lentine Reply:
April 3rd, 2013 at 6:50 am
Oh, yes. OID interest is generally taxed as normal income.
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A little late to the party here but how are returns from P2P platforms treated for tax purposes? As interest or as “normal” income?
Thanks!
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Tek Lentine Reply:
April 3rd, 2013 at 6:47 am
Hey, Brent:
Hopefully you’ll see this response to your question about taxes.
Prosper notes are treated as OID (original issue discount) instruments for tax purposes. This basically means that the amount of interest you are expected to receive over the life of the note is divided up and claimed in pieces each tax year.
Prosper’s calculation for OID interest that you owe taxes on for the year will be sent to you in the form of a 1099-OID form. Keep in mind that the number on this form may or may not be accurate depending on your investing strategy, but if you use their calculation, you should be safe from an IRS standpoint.
Hope this helps!
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