Monday, March 17, 2008

Eleven perspectives on P2P lending

We recently received a question from a reader who wants to get started P2P lending through Prosper. His situation is similar to many who discover P2P lending and are enticed by the attractive returns and wonder if it is too good to be true. We have collected eleven different responses from personal finance bloggers and lenders.

Most are cautiously optimistic but recommend lending only a small portion of your overall portfolio. If you do lend, start slowly and remain diversified.

Reader's Question: I am in my mid-30's. I am not rich, but I am pretty good at living within my means and have amassed a small nest egg, which I have slowly invested in different areas. I have some money in a mutual fund managed by Merrill Lynch, some in a similar IRA, some in a decent-yielding savings account (4%) and some, the largest portion, which I keep reinvesting in CD's. It is this portion that I am looking to try somewhere else, especially with the low CD return rates. Prosper seems like a great place to go, not only because of the higher return but because of the ability to choose whom you are helping.

My one financial question is this - if the loan is paid back slowly over 3 years, whereas a CD is usually short-term, say, 5-6 months on average, just how much better, really, is Prosper's return rate? Let's say you have $100k to invest and you have the following three choices:
  • a savings account with an APR of 4% (subject to market changes) for 3 years
  • a 6 month CD you keep reinvesting in, for 3 years, though, obviously, the market rate will fluctuate each cycle
  • an average of 10% ROI for $100k worth of 3 year prosper loans
Not knowing all the fees involved with Prosper, I'm a bit confused as to which of the 3 actually gives you the most money. Obviously, at first glance, Prosper is the best one, but...


Your thoughts on this would be much appreciated. I don't need liquidity; I just want something with a decent return. I have little faith in the future of the stock market, sensing major shifts in the world's economy over the next several years. For me, investing is important for the long term, so that by the time I'm old, my money is generating enough money to live on. I'm not sure I've found any investment strategy that would bring this about.






Matt from Prosper Lending Review

First, congratulations on your financial acumen. Living within your means is the most important thing when it comes to financial success. Investing for retirement in an IRA while you are still young is also a very smart course of action. As far as your question goes, there is not one investment tool that gives you the maximum return. Rather, there are investments that give you a potential for greater return, with the trade off being an increase in principle risk. Prosper is not FDIC insured and there is some risk to the invested principle, so it should really be viewed as a separate asset class. This should be kept in mind when comparing rates of return. That said, with a disciplined investment strategy I think you can earn a better rate of return at Prosper, though maybe not the 10% you are hoping for in today's market.

Let's take a look at the numbers.


These numbers represent Prosper's AA-B loans from its inception in November of 2005 through December 2007 with an observation date of March 5, 2008. These returns show past performance, and do not reflect some recent changes that have been made at Prosper. For example, Prosper no longer charges lenders a serving fee on AA loans. Nine months ago I wrote a article recommending investing in a diversified mix of A and AA loans. Although the default picture has grown worse since the post was written, following this strategy over the past year would have beat the 4% return from a savings account and the 5-6% rate of return on a CD. Note that 4% is currently a really good rate for a savings account (the national average is 0.41%), and 6-month CDs that were at 5-6% as recently as a year ago are now returning a dismal 3.1%.

So, what are the potential downsides of investing in Prosper in the near-term? First, the economic picture for the overall economy is starting to look worse. Default rates have been rising at Prosper as they are defaults on mortgages, credit cards, auto loans, and most other types of credit. Higher future default rates have the potential to erode future profit margins. Second, it may take some time to invest $100K in AA and A loans. The market is not liquid enough yet to invest that much all at once in a diversified and targeted approach. Also, a small adjustment has to be made to the rate of return based on time that the money sits idle in your Prosper account. Money sits idle in a Prosper account earning no interest during the bidding process and the loan verification process. In some cases loans fail to fund due to failed verification or a borrower backing out at the last minute which can increase the time that the money is idle. Overall, the reduction to your first year's return is in the neighborhood of 0.5-1%, and since some loans pay off early the long term reduction to your return is probably around 0.5% APR.

What is the likely near-term scenario? If current trends continue I would assume that defaults increase to around 5% for AA loans and 9% for A loans as the economy worsens and existing loans age. Next, I would subtract the 0.5% for time when the money is idle and 1% on Prosper servicing fees on the A loans. This results in an expected APR of about 4%.

What is the worst case scenario? The worst case scenario is that the economy goes into a deep recession. Even people with good credit find it hard to pay back loans as people lose their jobs, inflation increases, and house prices continue to decrease. Under this scenario you could experience a negative return. I don't consider this to be the likely scenario, but it is important to realize that there are risks involved.

Now, what are the risks to leaving it in savings and CD accounts? The good news here is that the principle is FDIC insured, and you are guaranteed not to lose any money. The risk is that the Fed keeps cutting interest rates and your bank is forced to lower the interest rate on your savings account to 1-2%. CDs also follow the downward rate trend, and the 3.1% interest on 6 month CDs drops to 2% when you reinvest. Inflation picks up and comes in at 5% (we are currently at 4% inflation, with core inflation at 2.5%). Under this scenario, you are at a negative rate of return relative to inflation, while with Prosper there is a potential for keeping pace with or possibly beating the rate of inflation.

None of these are spectacularly exciting options, but with the looming economic slowdown I don't think investors should be expecting the same returns that we have seen in recent years regardless of the investment vehicle. Keep in mind that these are short term predictions. As the economy improves and Prosper's collection efforts improve I think we could see an overall decrease in the default rates over the longer term. As that happens Prosper's rates of return should improve. From a longer term perspective I think conservative Prosper portfolios should continue to outperform CDs and savings accounts.

What would I do? I would ask myself: In the event that things get really bad in the next couple of years would I lose sleep over a negative rate of return in the short term. If the answer is yes then I would keep the money in a CD or Savings account for the short term. If the answer is no then I would slowly start investing money into Prosper. If I were investing $100K I would start with about $1-2K per month until I reached a comfort level with my ability to understand and pick loans based on the credit criteria provided. Once I reached that comfort level I might increase the investment rate to $5K-$10K per month. The marketplace just isn't big enough yet to efficiently invest the $100K all at once while maintaining a diversified portfolio. Also, if you do make some beginner mistakes on loan selection it would be better to do that on a smaller portion of your portfolio rather than on the entire investment amount.

Another option if you want to put your money to work helping people while keeping the FDIC insurance is to take a look at Zopa. At Zopa your rate of return will be about the same as you get from a CD, but you will be able to pick the recipients of the loans. With Zopa you have to join one of their partner credit unions and deposit your funds with the credit union. The credit union assumes the default risk and keeps your money in a FDIC insured account.




Mike from Prosperousland

There are two elements to this question. First, which of three investments should be chosen? Your reader seems comfortable with locking money up for 3 years, but doesn't appear to be very risk tolerant. "Seasoned" Prosper lenders have had returns vary from +25% to -40%. (6 months or older average loan age, more than $5000 invested). And the median "seasoned" lender ROI, as estimated by LendingStats.com, is closer to 5.3%. In other words, there's a lot of risk and possible volatility for a little increase over 4%. If this makes your reader at all queasy, they best avoid Prosper and go with one of the other alternatives. Prosper is advertising 10% returns going forward, but they do not have a large set of data to back up that history. It is Prosper's best guess, but that doesn't ensure success. Based on your reader's apparent risk aversion, I'd avoid Prosper. If Prosper can deliver more predictable returns for a couple years, then I would consider making Prosper more than a token (<5%).>

As to the second element to this question, I'm curious why your reader is only considering short term bank accounts (6-month CDs or savings accounts) when their time horizon seems much longer than 3 years. There's a wide variety of investment options that I'd consider that covers the spread between short term bank accounts and Prosper. Anything from long-term CD ladders (5-year CDs with staggered maturities) to a portfolio of index mutual funds in stocks and bonds should have more consistent returns with less uncertainty. I'd start there instead of moving aggressively into Prosper.




Response from Prosper

The three investment choices that are being considered all have very different characteristics so the choice of vehicle really depends on what is most important to the consumer. As stated in the question the consumer is looking for the best return and is concerned about liquidity. Given this set of objectives a portfolio of Prosper loan is an excellent alternative.

A savings account will have the lowest return of the three choices mentioned. In addition, the rates on savings accounts have fallen dramatically in the past few months with market rates. Most consumer savings accounts are paying rates below 2% today (there are exceptions… for example, ING Direct at 3.4%). The main advantage of a savings account is liquidity, and exchange for this the consumer will give up return.

The best way to compare a CD investment to a portfolio of Prosper loans is the match the average term of a Prosper loan to the current CD rate for a similar term. Because a Prosper loan is a amortizing loan with principal payments made over time the average life of a Prosper loan is less than two years, the best CD rate to compare to the return on a Prosper loan portfolio is 2 years. The national average rate on a two year CD, currently 3.1%, will roughly approximate the expected return on 4 consecutive 6-month CD investments. A two year CD has different liquidity characteristics than a Prosper loan portfolio, and commonly there is an option to pay a penalty to liquidate a CD before its term expires. If both are held to maturity the Prosper portfolio will begin returning funds more quickly, but the funds will be paid back over a longer term.

A portfolio constructed using Prosper’s Conservative portfolio plan has an expected return of 7.00%. Although Prosper loans have repayment risk, the expected loss rate on the conservative plan is 1.35%. Losses would need to be 3 times expectations for the return on the Prosper loan portfolio to fall to the level of the 2 year CD. Based on the stated preferences of the consumer, a portfolio of Prosper loans created using the conservative portfolio plan is the best choice. Depending on the consumer tolerance for risk, there is an opportunity to earn an even higher return than 7.00%.



Brett from Personal Loan Portfolio

Fantastic question! The primary goal is to maximize your return for the portfolio at your risk tolerance, so I am going to address more than just peer lending. You have a sum of money that can be diversified across several investments, so this is not an either/or decision. My primary recommendation is to spread your risk across a few different investment types.

Consider Fees: First, how much are you paying in fees on you Merrill and other IRA? I suggest that you check your fees and consider consolidating your IRAs at Vanguard in an index fund due to their low fees. (Check your capital gains tax consequences before selling a fund.) Consolidation also simplifies tax filing and account management. Reducing fees will have a significant impact on your returns over time. If you are concerned about the US stock market opportunities, consider a fund such as Vanguard's International Index fund. As for peer loans, typically you will pay 1% of the interest you receive in fees.

Consider Your Time frame: You mention you are looking for retirement income. Most of this money will be spent 30 years from now! There have been bumps along the history of the stock market. You might instead consider this down market a bargain rather than worry about any short term risks in the stock market.

Consider Taxes: Interest income is taxed as income while dividends are taxed at the lower capital gains rate. Stock price appreciation is taxed at the capital gains rate, and is deferred until the stock sale. I posted an analysis of tax impact on P2P loans. Over the long-term (using real historical data and not averages which reduce the impact of volatility), the S&P 500 seems to be a better investment than even a 12% return on peer loans. I included a spreadsheet in that post that you can download and change parameters on to compare the alternatives for your personal comparison.

Take advantage of all the tax-reduced possibilities available to you before peer loans. For example, if you are eligible for the ROTH IRA, I would recommend that as an investment before peer-to-peer loans. The Roth can be withdrawn without penalty in case of emergency, so I have occasionally drawn down non-tax-advantaged savings to fund my Roth IRA.

Consider Broader Market Risks: The market risks causing you concerns about the stock market are also impacting the credit market. The credit market that is driving you to seek higher returns from other options is also causing more risk from borrowers. Mortgage foreclosures are at an all-time high despite federal help. Homeowners may be turning to peer lending to patch (not stop) the bleeding caused by interest rate resets on variable rate mortgages. Energy prices could also impact borrowers. Could the borrower sill make payments if gasoline rises to $4 per gallon? What about $5 per gallon? Energy prices are also causing utilities and food prices to increase. Without a doubt, borrowers will pay their mortgage, their electricity, and their food bill before they pay you. After a loan goes into default, it is sold so even if the borrower recovers and pays off the loan you only got pennies on the debt sale.

Consider Wading Into Peer Lending: Peer lending takes some time to learn. Most of the more experienced lenders that I asked in my post about advice for new lenders indicated that they made mistakes at first. Therefore, I suggest that you slowly enter into peer lending. If you are doing this for the long term, the opportunity should still be available to you a year from now. So invest a reasonable sum each moth such as $500, and think about your choices for a while. Then, next month invest another $500. By the end of 12 months, you will have $3,000 invested and you will be able to see if you are making reasonably good choices in loans. Again, your time frame is 30 years so forgoing a small return differential while you learn the ropes will not have nearly the negative impact of diving in like a muleshoes -- notice the bid pattern and the rate of return.

Consider the Historical Peer Lending Statistics: There are lots of statistics available on the internet. I think one of the more telling statistics is the performance of the top ten lenders on Prosper which is available on Lending Stat's home page. Drill in to see their ROI. Only two of ten are projected to earn slightly more than 8% and they have not arrived to the end of their three year loan terms yet. Or consider this statistic: Of the Prosper investors who have invested more than $10K in more than 50 loans that are on average more than nine months old (link to data pull), after you consider a 1% fee, only 12 of these selected investors out of 1191 are projected to make more than 10%. Therefore, I would reconsider your projected rate of return.

Spread your risks and do not believe in magic bullets. Peer loans may be a part of a balanced risk diet one day, but for now their history is not long enough for you to drop the meat, vegetables, carbohydrates and fruits in your portfolio. So take small bites. Best of luck to you in your decisions.



Brip Blap

Prosper pays a better rate, despite the "locked-in" nature of the loans, for one reason - risk. A CD is far less risky than a loan to an anonymous stranger through the Internet, no matter how much information is collected about that person. If you are truly interested in wealth-building, Prosper (or any P2P lender) can never be more than a portion of your investment portfolio. I am skeptical of the 10% ROI on Prosper loans you mention, simply because we don't have a long history of default rates to study yet. With the worsening economy a possibility also looms that the default rate could significantly worsen. And Prosper itself operates in a new market niche - a "Prosper-killer" could come along and wipe out Prosper. All of these risks require the mitigating factor of above-average gains.

Yet at the same time, I can predict that a 5% CD will never earn more than 5%. A 13% Prosper loan (if it doesn't default) is better than a 5% return. If you are willing to put the time into studying borrowers and really minimizing your default rates, your rate of return will be better than a CD. Period. I would never make high-yield savings, CDs or P2P loans a significant portion of my investment portfolio but each of them has concrete value as a diversifying tool. Just keep increasing your financial knowledge - which you are doing by asking questions like this - and you can't go wrong.



A Lending Club lender

I suggest that he look at putting money into Lending Club. He has addressed two important components of an investment strategy: liquidity and return, but he is missing another important consideration: volatility and risk.

CDs are less risky, less volatile and slightly more liquid than P2P lending. P2P lending is less liquid (although the 3 year term is offset by the monthly principal and interest, which lowers the effective duration of the investment), more volatile, and has higher returns.

Within P2P lending, a lender can decide which end of the credit spectrum to lend to - the further up the credit score distribution you stay, you get lower returns, but much more predictably. If you stay in the mid range (12-18%), you are getting significantly higher returns with fairly predictable volatility.

Once you go much lower into the credit spectrum, you are potentially making great returns, but they are subject to a significantly higher amount of risk and volatility.

I also recommend that to reduce volatility, he lend to dozens or hundreds of borrowers in the risk/return range that he wants to pursue for added diversification and lower concentration risk.



Pinyo from Moolanomy

One thing that immediately jumped out at me is that you are comparing risk-free investments (i.e., savings account and CDs) with investments with risk (i.e., Prosper). It should be clarified right away that with savings and CDs, you can't lose your principal and the interest - it is guaranteed. On the other hand, you could lose all of your money with Prosper and other peer-to-peer lending networks (i.e., borrowers all decide to default). However, the scenario is unlikely if you choose borrowers with some due diligence.

Secondly, it seems that your view of the stock market is short-sighted. With over 30 years to go in your investment horizon, the stock market is still the most attractive option. Remember that the stock market has been around much longer than peer-to-peer network, and it has proven track record. Currently, peer-to-peer is less than 1% of my net investment, and I wouldn't allocate more than 5% of my net investment to peer-to-peer lending.

My suggestion is to first focus on investing in the stock market. I am not talking about picking individual stocks, or limiting yourself to U.S. equities. I believe the best strategy for new investors is to build a globally diversified portfolio of passively managed funds and ETFs(remember to keep the expenses low!).

Personally, my investment is about 70% domestic and 30% international witha plan to shift the allocation toward 50-50. In each category, I diversified across different size companies in different sectors with a good balance between value and growth companies. Also, it also doesn't hurt to invest a percentage of your portfolio in other types of investment-- i.e., bonds, precious metals, real estate, etc.

If you really want to try out peer-to-peer, I suggest that you start small and then build up your position slowly. Again, I wouldn't recommend investing more than 5% of your total investment.



Dough Roller

Your question raises a very important issue relevant to any investment-- risk adjusted returns. As you acknowledge, simply comparing the interest rate on several fixed income investments doesn't tell you all you need to know before making a decision. You also need to look at the risk of each investment. Here, both savings accounts and CDs typically are FDIC insured up to $100,000. That means, among other things, that the risk of loss on these investments is negligible. In contrast, P2P lending does come with the risk that the borrower will default on the loan. While some look at default risk with fear and uncertainty, it is actually the precise reason why a Prosper loan pays more interest than say a CD. Without that risk, you wouldn't be in the position to make more with your money. The key then is to make sure you mitigate that risk as much as possible. At Prosper, there are at least two ways to do this: (1) spread your money across many loans rather than concentrating your investments in just a few loans; and (2) invest in loans issued to borrowers that present varying degrees of default risk based on their credit score, debt-to-income ratio, and other risk factors.

Finally, I would encourage you to rethink your fear of the stock market. We certainly are living in volatile times right now, but that volatility could hit any investment, even a Prosper loan. I invest in Prosper loans, the stock market and real estate. Each of these investments present varying degrees and types of risk. But by diversifying across multiple types of investments (just like diversifying across multiple borrowers at Prosper) I mitigate the impact a loss from one investment will have on my entire portfolio. Of course, this is just my opinion, and you'll need to make your own decision based on what you think is best for you. Good luck!




Ana from Debt Free Revolution

That's a tough one, but I would personally snap up some more funds. I've been finding a lot of old articles from back in the late 70s saying the only people who still bought equities were the old folks, and how un-hip and un-savvy that supposedly was. Of course we all know what happened with the markets in the 80s.

Another thing I would look into if it were my cash, is to start looking for good real estate bargains. Experts are now saying real estate will be "down" for the next 3-5 years; translation "on sale." In The Millionaire Next Door, Thomas Stanley asked several high net worth folks when the best time to buy real estate was. Their reply was in the early 80s, when interest rates were astronomical and next to no one was buying at that time.

It's not "conventional wisdom" but then again I am not quite conventional!




Kevin from Rateladder

My response to your question sounds like I am talking you out of investing in p2p lending. Nothing could be farther from the truth, but within the framework of your question p2p lending is an unknown and your question does not support investing in an unknown. The returns may materialize and they may not.

As much as I believe that p2p lending will change the world it is an entirely new asset class. You cannot assume the published rates of return will be the actual rates of return. It is different than credit cards it is different from secure debt. I would not recommend putting more than 5% of your overall portfolio in P2P lending. If your 5% of your overall portfolio is less than $2,000 I would not invest in p2p. The tax treatment of a p2p lending portfolio is harsh.

If you are still reading my answer then you may like the rest of my response…P2P lending in fun. It is a wonderful feeling to both help someone and generate a return on your money. It is financial voyeurism…once you start you cannot stop. It is highly addictive and enjoyable to invest in p2p lending, but guaranteed results (or even significant past results) are lacking… Proceed with caution, fully diversify (I think at least 50 loans), and have fun, but don’t bet the farm.



Lazy Man and Money

I don't think tying the largest portion of your money for 3 years in P2P loans is a wise idea. In fact, the investment vehicle is so new that no one really knows how it will perform. I'd rather have more of my money diversified amongst US stock, international stock, bonds, commodities, and real estate. Along those lines, here are some ticker symbols of low-expense index funds to look into: VTI, VEU, BND, DBA, VNQ. I would feel comfortable with this diversification - I don't see everyone suddenly deciding that stocks (all over the world), bonds, food, and real estate suddenly have no value.

So I wouldn't steer you completely from P2P lending sites, but I think it's wise to dip a toe in over the next couple of years.




If you made it this far, consider these additional articles about peer to peer lending:

How does Prosper compare to other investments?
Prosper: A hands-on education in risk management
Why would a borrower use Prosper instead of a bank?
Borrowing money to lend on Prosper: Wise or Foolish?
Most Prosper lenders do not diversify
Are all Prosper loans within a credit grade created equal?
An analysis of pre-payment risk on Prosper loans
Are non-homeowners a safer lending risk in a declining house market?
What effect would a recession have on the Prosper marketplace?
Credit Scores on Prosper - Part 1 of 2
When to bid on Prosper loans

6 comments:

Brip Blap said...

That's an excellent bunch of responses - very interesting reading. I'm not just saying that since I'm included - it really is a good analysis, across the board. Thanks for putting this together.

Steve

RateLadder said...

Well done PLR. I am stumbling and redditing and digging this article. I suggest others do the same. Awesome job.

Anonymous said...

Yes, this is not only incredibly helpful, but a lot of food for thought. Will have to spend a few days processing this..! Thanks so much!

Personal Loan Portfolio said...

Thanks for including my advice.

I agree with RL, everyone involved should social bookmark this post in some way. I already added it to http://del.icio.us/

sb10 said...

Speaking of the worsening economy, I emailed a suggestion to Prosper this morning saying that I would like to be able to screen borrowers to see whether they do NOT own a home. I consider relatively recent homeownership in certain areas very high risk and would prefer to lend to non-homeowners in these areas.

Perhaps traditionally, homeownership has been a major consideration when assessing how financially responsible a borrower is (the mortgage borrower has been perceived as more responsible), but I don't think that is necessarily the case anymore.

Tom said...

sb10 - you can screen borrowers by homeownership. It is one of the search criteria.

Also, you may want to check out Matt's article about home ownership:

Are non-homeowners a safer lending risk in a declining house market?