What Happens When A P2P Borrower Stops Paying?

I’ve been an investor with Prosper, a peer-to-peer (P2P) lending company since 2012. I usually check my account once a quarter to view my performance and to re-invest cash that has come in from borrower payments. Per my latest passive income update, the annualized return of all of the notes in my portfolio is 7.41%. Better than a swift kick in the nuts!

With rates expected to rise by perhaps as much as 2% over the next several years, I suspect the returns on P2P lending will also commensurately increase. As a result, I plan to allocate more of my free cash flow into Prosper in $10,000 increments. 

P2P BORROWER STOPS PAYING

One of the reasons why it's taken me so many years to put real money behind P2P lending is because I absolutely hate debt welchers. Even though debt welchers are now glorified in the media thanks to the accepted norm of blaming other people for our financial situations, I still have a hard time dealing with people who don't honor their promises. My fear of lending money to a debt welcher finally came true the other day.

When I logged in this week, one of my notes was in collections! The loan status was highlighted in yellow “Late (15-30d) In collections.” I felt betrayed! What surprised me even further was this particular loan isn’t one of my “C” or “D” rated notes, it is a “B” rated loan!

As soon as I found out one of my notes was in collections, I wanted to know everything I could about the borrower and this particular note. Here’s some of the information I pulled about this particular note:

Loan category: Debt consolidation
Rating: B
Principal: $10,000
Borrower rate: 14.85% over 5 years
Borrower’s monthly payment: $237.11
Lender effective yield: 13.04%
Estimated loss: 5.99%
Estimated return: 7.05%

And this is a snapshot of the borrower’s credit profile at the time they applied for the loan:

Based on the data, it still seemed strange that this particular borrower was in collections. Was there something I was missing? Had he lied about their income, become unemployed, or gotten buried in medical bills?

If by some chance you're the one whose stopped paying their loan, we need to have a serious talk! I had a call with Prosper to find out more.

THREE VALUABLE LESSONS LEARNED

Check if a borrower has already taken out a Prosper loan – The maximum number of loans any borrower can have through Prosper is two. Not all borrowers can qualify for multiple loans, however. They have to meet certain credit score requirements, have to be current on their existing payments, and need to meet a minimum number of consecutive monthly payments.

Also, the total amount of the loans combined cannot exceed $35,000. I like to handpick my notes instead of using the Quick Invest feature because I like to shop around and find the most promising investments available by rating.

Unfortunately, I completely failed to notice the borrower who has stopped making payments had already taken out a $25,000 loan. I thought they were only trying to borrow $10,000. To top it off, the $25,000 loan was for a vacation! If someone is borrowing that much money to take a vacation, they are not properly managing their finances! If I had seen that red flag at the time, I would have declined to lend immediately.

When you’re browsing listings, the quick way to tell if an applicant has already borrowed from Prosper, is the Prosper Activity section at the bottom. It seems so obvious now, but I totally overlooked this in the past. The Prosper Activity section will simply be absent if an applicant has never taken out a Prosper loan – in other words you won’t see a loan history of zero. Here’s what you do:

1) Browse to the bottom of an active listing and check if the Prosper Activity section appears. If it does, take a look at their past/existing principal borrowed, principal balance, payment history, and credit score history. Take note if their credit score has declined since their first loan.

2) Scroll back up to the top of the listing summary and click on their borrower profile link.

3) This screen is where you can see the category of their first loan and when they applied. It’s a bit of a roundabout way to get the information, but I find it’s valuable information when determining whether or not to invest in an applicant’s current listing.

Borrowers aren’t able to change their loan due dates – When I was talking to Prosper to learn more about the collection process, one item that came up was due dates. Borrowers can’t change a loan’s due date, which is something Prosper could improve on in the future. As of now a loan’s payment due date is determined by each loan’s origination date at the start of the loan and stays that way for the full duration.

Since payment dates aren’t flexible, if a borrower has two loans the due dates likely differ. Borrowers can’t combine loan payments either, they have to made separately for each loan. As a result this can trigger late payments on one or both loans if they are tight on cash short-term due to timing issues.

I noticed that although my borrower was late on my particular note in June, he/she made the June payment for the Vacation loan on time.

A loan's listing summary is static – My fears that this borrower had lied about his/her income were quickly overcome. The Prosper rep assured me that during the listing process, if any information the borrower input is found to be false or if he/she can't supply documentation, the listing falls through and the borrower would have to start all over again. This means that since my note was successfully funded, there was enough data provided to verify he/she had income over $100,000.

This means that anytime you are browsing for new notes, you don't have to worry about any of the listing's information changing between the time you put in an order and the loan getting funded. If false information is found or the borrower doesn't supply all the required documentation, your order simply won't get filled.

I also found out that once you purchase a note and view the listing summary, none of the information changes. Thus, you can't access the borrower's current credit score. You'll only see a snapshot of their financial profile at the time the listing was created. If the borrower so happened to take out a second note with Prosper later, then you could navigate to see their credit score at the time of the second listing. You won't be able to view a borrower's current credit score, income, revolving credit balance or any other updated profile information.

WHAT HAPPENS WHEN A BORROWER STOPS PAYING?

The collection process – Here’s the rundown on what happens if one of your borrowers is late on a payment and stops paying.

1-15 days: Prosper sends emails and calls borrowers about late payments. Two attempts to withdraw funds electronically are made. Missing the first payment results in a $15 fee. Failing the second attempt results in the greater of $15 or 5% of the unpaid installment amount.

16-30 days: Prosper’s in-house collection agency is engaged first to try and collect funds.

31-120 days: Prosper then engages a 3^rd party collection agency to take over and attempt to collect the amount due including accrued fees. Late fees continue and are charged at day 46, 76, and 106 days past due. Experian and Transunion are notified on a monthly basis of the delinquency, which now shows in borrowers’ credit history. Borrowers’ credit scores start to take a hit.

121+ days: Things aren’t looking good at this point and the loan is charged-off. What this means is a borrower is still obligated to make payments, but the entire balance gets accelerated and is now collectible in full as of the charge-off date. Late fees stop but interest continues to accrue. Experian and TransUnion are notified, the charge-off appears in the borrower’s credit history, and their credit score takes another hit. These borrowers are immediately disqualified from taking out any loans with Prosper in the future. After a loan is charged-off, it is put up for sale. If a debt buyer purchases it, any proceeds will be distributed to lenders. But there are no guarantees it will be sold. Lenders just have to wait at this point and hope to get some money back. There’s no set time frame on how long it could take or how much the charge-off could be sold for.

Collection agencies will charge fees (up to 40% any recovered funds, plus legal fees and expenses) for any recovered funds that get deducted. What sucks for investors is these fees are deducted from any recovered funds and paid to the collection agency. But at least lenders do not have to front any collection fees if no funds are recovered at all.

NON-PERFORMING LOANS IS AN INEVITABILITY

With a large enough loan portfolio, having a non-performing loan is an inevitability. For big banks, the ratio is generally between 1% – 2%. But given I've got less than 50 loans out, most of which are A's and B's, I'm rocking a much higher NPL ratio.

With my planned injection of capital, I will get my NPL ratio down so that no one loan can do that much damage to my overall returns. The way things stand right now, if another loan goes into collection, this year's return could easily drop by 0.5% to under 7%.

I've come to terms with the fact that there will always be people out there who don't make due on their promises. So long as I don't know who they are or run into them, everything will be OK. It's just a part of doing business.

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Updated for 2018 and beyond.

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.