Thursday, July 5, 2007

An analysis of pre-payment risk on Prosper loans

There are many risks associated with lending money at Prosper. The primary risk is that loans will default or will have some late payments. The risk with a default is that the loan is sold off for pennies on the dollar, so most of the money invested is lost. The risk with late loans is that if payments are eventually made that bring the loan current a credit agency will take part of those payments as a collections fee. Of course, if payments are not made to bring the loan current, it will eventually end up in default. There are other more remote risks such as the risk that will go out of business. There is another risk, however, that is often overlooked: the risk of loan pre-payment.

Pre-payment occurs when a borrower pays more than is due on the loan, causing the loan to be paid off earlier than originally scheduled. Sometimes this is done by doubling up on payments, and sometimes it is done by making a lump sum payment for the balance due on the loan.

You may be thinking why is this a risk? After all, when a loan is repaid in this manner you are receiving all of your principal back plus interest for the time the loan was active. This is true, and it is certainly better than having the loan go into default. However, it is worse for the lender than if regular payments had been made according to the 3-year loan schedule.

When the loan is pre-paid, and the lender re-invests the money it is possible that it will be done in worse market conditions (i.e. interest rates may have gone down). Also, the interest earned from the good loans in your portfolio offsets the money lost from bad loans that end up defaulting. So, if your good loans pre-pay then you are making less money on each good loan, which decreases overall earnings. In addition, it takes time to bid and re-invest the money, so the money may sit idle for a month or more after a repayment at no interest until it is reinvested.

There are a variety of reasons why a borrower might choose to pre-pay a loan.
  • If their credit score improved they can refinance at a lower rate.
  • If the money was for a short term need such as flipping a house or buying inventory they might re-pay once they have reaped the profits from their investment.
  • They might accelerate payments to get out of debt quicker.
  • They might choose to consolidate their debt to reduce the number of payments they are making to creditors.

Banks understand the risks associated with pre-payments, and it is the reason that some banks charge pre-payment penalties on loans that are paid off significantly ahead of schedule. I don't have any great advice for avoiding this risk, but as with all investment risk I think it helps to be aware of all risks associated with an investment when deciding to invest. Also, unlike defaults I don't fault the borrowers for this additional risk; if I was in the borrower's shoes I would also pre-pay a loan if doing so could save me money on interest payments.


Tom said...

It would be interesting to run some stats and see who is most likely to pre-pay their loan.

Mike said...

I want my default risk spread across as many loans as possible, so I'm pleased when ever I get prepayments. I'm convinced (though I havn't played the stats game yet) that I need 50+ loans to properly spread out the risk (each loan worth <2% of my portfolio). I'm not there yet, so I'd rather have (for example) 50 loans @ $25/ea versus 25 loans @ $50/ea. The only way I'm getting there is through prepayments.


Matt said...

MIke, I agree that diversification is important. Partial pre-payments could help achieve diversification, but whole pre-payments (where the entire loan is paid off) could end up hurting your diversification. If you have a loan where the remaining balance is $35 and they pre-pay the entire loan then when re-investing you are going to have to do the $50 minimum loan payment again making a small portfolio less diverse.

Anonymous said...

The biggest issue with pre-payment for me is actually the length of time it takes to re-invest the pre-payment. If re-investment was immediate, there is much actualy risk at all. However, since I have money sitting in prosper for over three weeks, the effective return is significantly reduced with early payment. (3 weeks: process of bidding, out-bid, re-bidding, loan approval, loan-rejection, etc, etc. )

Anonymous said...

I am interested in the *cost* associated with the pre-payment. I would like my 1% lender origination fee to span the promised 3 year loan. If I facing loans that prepay every year, my costs triple and my expected return for the 3 year investment window is hammered. On the other hand, Prosper gains multiple fees.

Tom said...

I thought this was interesting. Current prepayment stats on Lending Club loans:

Prepaid $1,452,450 (5.33%)