Wednesday, August 1, 2007

How does Prosper compare to other investments?

There are many different ways to measure an investment. We might ask questions like: What is the potential return? What is the risk? What about liquidity? What fees are involved? What are the tax consequences for the investment returns? Are there tax benefits to losses that might be incurred? How time intensive is the investment? Can it target specific objectives like saving for college or retirement? How is it treated when part of an estate if the account holder passes away? Can it be used as a hedge against events that negatively affect other investments? In general, how does it compare to other investments?

Lets take these questions one at a time to see how Prosper stacks up:

Q1: What is the potential return?

A1: Interest rates on loans on Prosper fall between 6% to 29%. Current performance indicators suggest that one can expect to earn between 8%-12% after defaults with a disciplined investment strategy. To obtain these rates investments should be made in higher grade loans for borrowers with good credit scores (preferably to borrowers with no delinquencies in their credit report).

Q2: What is the risk?

A2: The primary risk on Prosper is that loans will default, or will be late in making payments. Loans that default are sold off for between pennies on the dollar to as much as 30 cents on the dollar for homeowner loans in the higher credit grades. Late loans are turned over to a collection agency, and any recovered payments will be subject to recovery fees paid to the lending agency. Default rates increase as credit grade decreases. You can view default rates and expected rates of return for different types of loans at Prosper's Marketplace Performance page.

Q3: What about liquidity?

A3: Prosper has very little liquidity. The only way to pull money out of Prosper after it is invested is to wait for the borrower to make payments over three year term of the loan. Prosper has indicated that they are working on creating a secondary market that would increase the liquidity of the money invested.

Q4: What fees are involved?

A4: Lenders pay an annual loan servicing fee of between 0.5%-1% depending on the credit grade of the loan. Lenders are also responsible for collection agency recovery fees on any loans which go more than 1 month late. These fees range between 7.35% and 20% of the amount recovered by the collection agency.

Q5: What are the tax consequences for the investment returns?

A5: Any money earned on Prosper is taxed as ordinary income and subject to Federal income tax rates which can be as high as 35%, and state income tax rates which vary between 0% and 9.3%. Prosper is not a tax friendly investment.

Q6: Are there tax benefits to losses that might be incurred?

A6: With some assets, including stocks, it is possible to use losses to offset taxable gains from other investments. You can also decide when to sell a stock based on whether doing so would be advantageous for tax purposes. On Prosper it is not possible to use a loss to offset a taxable gain from another investment. Also, on Prosper is not possible to time the receipt of income to postpone any tax liabilities.

Q7: How time intensive is the investment?

A7: Much like researching out an individual stock before you purchase it, each Prosper loan requires a bit of research to determine whether it is a good investment. It is possible to set up standing orders that will auto bid based on a pre-selected set of criteria to reduce the amount of time required. Many investors, including me, enjoy the process of researching and selecting loans to bid on, but this should be considered a time intensive process.

Q8: Can it target specific objectives like saving for college or retirement?

A8: There are many investment programs that target a specific savings goal. There are a variety of state run 529 plans are setup for saving for college. 401Ks and IRAs are setup for retirement savings. Other investments are setup specifically as tax-friendly investments. Prosper is none of these. I guess there is no reason that you can't use Prosper for saving for retirement or college, it is just that you will not get the tax benefits or employer match benefits that can be available from some of those more targeted investment options.

Q9: How is it treated when part of an estate if the account holder passes away?

A9: Understanding how investments fit into an estate planning scenario can be very important. When properly structured, many investments can be passed on to heirs tax free and often taxes will not even need to be paid on unrealized gains from an investment. When not properly structured, estate taxes can significantly reduce a person's assets. Let's take an individual stock for example. Let's say you purchase 1000 shares at $5 per share, and over the years that stock increases to $80 per share. If you were to sell it, you pay taxes on the $75,000 in earnings at the capital gains tax rate (currently 15%). If you instead pass it on as part of an inheritance to your heirs, they can receive what is known as a step up in basis. That means that if they were to sell the stock they can list their cost as $80 (the value of the asset at the time they received the inheritance) and they do not pay any taxes on the $75,000 in profit. A similar tax savings can be realized if the stock is donated to charity - in that scenario the money can also be earned and donated without anyone paying taxes on the earnings. In Prosper, there is no way to avoid the taxes. As money is earned from Prosper loans it must be realized as income and the taxes must be paid.

Q10: Can it be used as a hedge against events that negatively affect other investments?

A10: Often investors will look for investments that will reduce their risk to negative events by diversifying in investments that move independent of each other. For example, airlines will invest in oil futures in such a way that if oil prices increase then they make money on their investment. If oil prices decrease then they lose money on the investment, but they realize an overall saving by having to pay less money to fuel their planes. This lowers their exposure to the risk of a sharp increase in oil prices. Prosper does not target a specific commodity or investment for hedge purposes, but it can be considered an independent asset class in much the same way that stocks and bonds are separate asset classes. As such, it does offer value as a means of diversifying an investment portfolio.

Q11: In general, how does it compare to other investments?

A11: I think the best use of Prosper is for diversifying an investment portfolio so that you don't have all of your investments in stocks and bonds. Adding some Prosper loans should increase the overall diversification of your portfolio. Combined with a conservative investment strategy I think it can provide better returns than bond funds. Prosper should not be considered a good place for money that might be needed for emergency purposes since there is very little liquidity in the investment. Also, it is probably not the best investment for retirement money unless you are already maxing out any 401K or IRA accounts that are available to you. If you are relatively new to saving and investing I would suggest starting with an emergency fund equal to about 3-6 months of your salary. This money can be kept in a money market or savings account. After that, if you have a 401K available at your work you should be saving at least enough to get you a full company match. Next, it is good to save additional money for retirement in a IRA. Additional medium to long-term savings accounts can then be setup with a mix of stocks, bonds, and Prosper loans. The allocation percentages should be determined by your tolerance for risk and your investment time horizon.

10 comments:

Tom said...

Matt, this is a great article. I think that very few people consider all these factors when they start lending on Prosper. I know I haven't.

When you look at all the downsides, it seems like Prosper should generally just be a small part of your investment portfolio.

Matt said...

Yes, some of the things they are working on like a secondary market will be helpful once that arrives. It would be nice if Prosper loans could be put inside of an IRA, but that is not currently possible, and I don't think that Prosper is working on that right now.

Anonymous said...

You can visit https://www.prosper.com/groups/group_home.aspx?group_short_name=INSTANTLOANS for your loan needs. This is our official lending group website on prosper. We recently started this group, but have been on prosper for past 12 months and have sucessfully funded 100s of loans on prosper.

Anonymous said...

Very informative! Thanks again!

Anonymous said...

ROI of invested time is not well represented. From most of the reading I've done and from people running actual stats on the system, the actual estimated returns (after accounting for defaults, but before taxes and fees) appear to be in the 8.5 - 9.5% range. Given this, the amount of time required to invest in Prosper loans appears to be better spent in researching and investing in stocks, or perhaps in starting a business. Plus, in financial terms, 9% is pretty low for a "hurdle rate" on capital for a risky investment.

Given this, Prosper appears to be more of an investment-hobby than an actual investment.

Bryan said...

Matt, could you please post a Q & A on the stability of the ROI. I have been investing on prosper for some time now, and I find your Q&A to be right on. One benefit of investing on prosper not covered is the stability, compared to other investments. Once you establish solid lending decision criteria, I find the ROI to be very steady. I like that aspect of prosper. Nobody is earning 20% on prosper (see lendingstats.com), but before taxes, I'm getting more than 10%, and reliably. I'm OK with that as a part of my portfolio.
Thanks,
Bryan

Anonymous said...

The tax system is still unfair to prosper type investors. If I lend out 2 loans of $50 each and make $10 profit on one and $10 loss on the other, why am I taxed on the $10? The balance sheet at the end of the day shows net gain of $0 (zero) dollars.
Hopefully some emendments will fix this in the near future. PK

Anonymous said...

When I look at loan performance stats for lenders with significant portfolios (>$10K, >50 loans) and with some history (>12 months avg loan age) you find the median estimated ROI is closer to 3%. Very few people are getting more than 8%. How come people don't seem to realize this? Most of the higher returns are just luck and the ones that claim skill probably have to spend a lot of time screening if true. Any way you slice it Prosper is a bad investment for most people.

David P. Owen said...

I was one of those who saw high interest rates and rushed headlong into Prosper. Mistake. Most of my loans are now in default and some have been charged off. I wonder how much the lawsuit affected borrower behavior, because all of my loans went late in October/November. This is probably all irrelevant though, since I doubt Prosper will survive 12 months of litigation.

Tom said...

David - I'm curious, how did Prosper compare to your other investments over the same time period? It seems even those that have lost money on Prosper through defaults have done better considering the poor performance in the market lately.