With savings interest rates under 0.3%, the 10-year yield under 2.5%, 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 2017. 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.
- Based on your state of residence, you may have to meet financial suitability requirements. For example, if you live in California and buy $2500 or less of Notes, your investment can’t exceed 10% of your net worth. And if you go over $2500 in Notes, the previous applies plus you need a minimum gross income of $85,000 on your last tax return and for the current year, OR a minimum net worth of $200,000 and total investments can’t exceed 10%.
- 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: 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: 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.
Wealth Building Recommendation
Manage Your Finances In One Place: One of the best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize your money. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances on an Excel spreadsheet. Now, I can just log into Personal Capital to see how all my accounts are doing, including my net worth. I can also see how much I’m spending and saving every month through their cash flow tool.
A great feature is their Portfolio Fee Analyzer, which runs your investment portfolio(s) through its software in a click of a button to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was hemorrhaging! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.
Finally, they recently launched their amazing Retirement Planning Calculator that pulls in your real data and runs a Monte Carlo simulation to give you deep insights into your financial future. Personal Capital is free, and less than one minute to sign up. It's one of the most valuable tools I've found to help achieve financial freedom.
Updated for 2018 and beyond. Lending volume for Prosper really died down in 2015-2016 as institutional investors pulled out. But volume picked back up in 2017 as interest rates remained low and institutional investors gained more interest.
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.