When to bid on Prosper loans

On eBay, there are tools that allow you to set a bid time, and swoop in and bid in the last second to win an auction. Getting your bid in at the last second prevents others from outbidding you and stops them from seeing in advance what you are doing. I was recently watching a house sell on eBay, and the winning bidder placed their first and only bid in the last seconds of a 30-day listing to win the auction.

On Prosper, the bidding is not quite as intense because multiple people can win small bids, so for someone to outbid you they may have to outbid several other people first. It is, however, helpful to understand the how the bid process works so you can make an informed decision when placing a bid.

First, the borrower chooses whether to auto-fund the loan or to open it up for bidding for a certain period of time. Let's say the borrower chooses to auto-fund the loan at 29%. This means that as soon as the loan is fully funded the bidding will end and the borrower will pay 29% interest; the rate will not get bid down. Auto-fund loans are denoted with a yellow lightning bolt next to the rate on the listing. Borrowers choose this option to get access to the money sooner rather than waiting for the rate to get bid down over several days. For this reason some lenders are wary of auto-fund loans especially in the high-risk credit group. Lenders see this as an indication of a desperate borrower that can't wait the few extra days to save a lot of money, or a borrower that doesn't care about the interest rate (possibly because they don't plan on paying back the loan).

If you do want to bid on an auto-fund loan you will need to make the bid before it hits 100% or the listing will close.

Most loans are for a set time period. These loans will show a green progress bar indicating what % of the loan has been funded. The loan will remain at the starting interest rate until the loan hits 100% funded. At that point each person that bids at a lower rate will knock off someone with a higher bid rate. As this happens the interest rate on the loan will be reduced to the highest rate among the group of winning lenders.

Let's give an example:

Bob the borrower starts a loan of $1000 at 16% interest. A, B, C, D, and E are lenders.

• A bids $500 at 16%
• B bids $300 at 12%
• C bids $400 at 15%

Now the loan is fully funded. C's bid reduces A's winning bid amount from $500 to $300 since C was at a lower rate. But there is still time left on the auction, and more lenders arrive.

• D bids $100 at 15%
• E bids $500 at 14.98%

So, the winning bids on the loan end up as follows:

• B - $300
• C - $200
• E - $500

The questions are: What is the rate that the lenders make and why is C on the loan but not D when they bid the same amount?

First, the lenders make 15% in this example since that was the highest rate bid among the lenders that remained on the loan (all the lenders make this amount even though some bid a lower interest rate than this). C remained on the loan because he placed the bid sooner than D. Note E made a smart move by bidding slightly lower than 15%. Many lenders bid in regular whole or half numbers, so bidding odd increments like .47 or .98 will often keep you on a loan while lenders with nearly identical but slightly higher rates get outbid.

So the question becomes: Is it good to bid early since that will keep you in line before someone else who bids the same rate?

The answer is: Not really. If you bid an odd number like XX.47 the chances of a significant number of others bidding the exact same number are slim. The more important consideration becomes whether or not the loan will fund. Many loans on Prosper end up not funding because there are currently more borrowers seeking loans than there are lenders with funds available (a good situation for lenders). The risk is that you will have your money tied up for several days on a loan that ends up not funding (once you have committed a bid to a loan it can not be withdrawn, and that money is no longer available for bidding on other loans).

So, bidding on a loan after it has reached >75% funded, or bidding on the last day on a fully funded loan increases the chances of being on a loan that will close fully funded. If a loan closes before being fully funded then the loan is cancelled and the money is returned to your account.

After a fully funded loan closes it goes into a verification process that can take 3-10 days before the loan is completed. During this time a loan can be cancelled if it does not meet the verification criteria. The most common reason for a loan not meeting verification is for failure to verify income. Prosper does not verify the income until the loan closes. Since this is a personal loan only personal income counts. One thing that you often see is someone who makes $40,000 per year has a spouse that makes $35,000 per year, so they put $75,000 for their income amount. This will fail verification because you can only include your income in the loan since the loan is being made to a single individual. The same is true for self employed people who put their business income rather than their personal income on the loan. Often, as a lender, you can spot this in the listing and realize that the loan is likely to not pass verification. If you don't want money tied up for a week on a loan that will end up being cancelled then it is wise to pass on those loans.

Analyzing Prosper data

Prosper has created a set of 3rd party tools that allow developers real time access to lending data on Prosper. This has allowed enthusiasts and academics to create all kinds of different ways of looking at the data. The most popular 3rd party site, LendingStats, allows you to view anyone's profile, get breakdowns of loans by state, credit grades, and group statistics. Other sites like Eric's Credit Community allow you to be notified when a lender places a bid so you can decide if you want to copy someone's movements, and lets you track "What if" profiles. Some websites have tried to quantify and graph exactly what the risk is associated with number of credit lines, number of inquiries, DTI, monthly income, and home ownership.

The fun part, for those of us who like databases, is that anyone can put all the data into a database and analyze it and graph it anyway they like. Right now only 18 months of data exist because Prosper has only been around for about 18 months. As time goes on, this data will become more detailed and much more accurate.

Theoretically, once the risk factors have been quantified for each item in a credit report, it should be possible, with a diversified portfolio, to calculate an approximate rate of return after accounting for expected defaults. Right now on the different websites you will see things like estimated ROI, Experian ROI, and EricCC ROI. Everyone uses different methods to estimate the expected return, and right now these can vary quite a bit. As more data becomes available these estimates should improve.

The current consensus based on analysis done to date is that on average HR loans return a negative rate of return after accounting for defaults. E's are slightly positive, and loans in the remaining credit grades average between 5-12% after defaults. Some people still go after the lower credit grades and try and cherry pick the better loans out of group with the hope that if they avoid too many defaults they will end up with a high rate of return.

I prefer to stick to higher credit grades with the knowledge that 5-12% is better than I can get in a CD or a savings account, and it is much more fun than buying a CD. It is a feel good investment knowing that there is a person on the other side of the loan that is being helped out by having access to needed money.

An introduction - lending through Prosper

Grameen Bank and its founder, Muhammad Yunus, won the Nobel Peace Prize in 2006 for their work making small loans to poor people with big dreams. Prosper is a website that tries to extend the microcredit idea via the web to all people, including but not just limited to the very poor. It's been called the eBay of Loans by Forbes Magazine, the #1 website of the year by Time Magazine and has received plenty of other rave reviews. Prosper describes their service here:

The way Prosper works is intuitive to people who have used eBay. Instead of listing and bidding on items, people list and bid on loans using Prosper's online auction platform. People who want to lend set the minimum interest rate they are willing to earn and bid in increments of $50 to $25,000 on loan listings they select. People who lend can easily diversify using "standing orders", which automatically make many small loans to different borrowers.

Although it may seem somewhat risky, Prosper takes many more steps than eBay to prevent fraud. Everyone's identity is verified. Credit scores are checked. Those borrowing money basically go through the same rigid process required by any normal lender. Monthly payments are made by automatic withdraw from the borrowers savings account. So far Prosper has been very successful with over $67,000,000 in loans. It provides loans to people who need it at a lower interest rate than they would be able to get through a bank or credit card and provides lenders (you) a higher interest rate than they might get through a savings account, certificate of deposit, or other investment.

My brother Matt has been lending money on Prosper for nearly a year. He's careful about who he lends money to. Mostly he loans money to people with AA credit ratings. So far he's earning more than an 11% return on his money. None of his borrowers have been late with a payment. This is his lending profile.

Some people choose to lend money to people with poor and high risk ratings. Although the average interest rates can be as high as 26%, the default rates are also quite high for E and HR. Prosper reports defaults to the credit agencies and hires a collection agency, just like a normal bank or credit card company would.

With a careful investment strategy, it looks like Prosper may provide good returns with managable risk. Here are some of Matt's lessons learned from his months of studying and investing on Prosper. He has posted these on the Prosper Forums:

Its up to the lenders to read the text. I don't rely on that for the loan though. I look at verified stats, and things that the group leader can vet. Something in the listing could encourage me not to lend, but I don't think anything written in the listing could get me to fund a listing that I wouldn't fund based on the verified stats alone. I am happy with Prosper overall. (forum post - Would you stop lending if...)

No lates for me yet, but I enjoy reading these threads to see what to avoid. So far I am learning to avoid:

• New business Ventures
• People with high number of inquiries
• Nurses who can't spell Nurse
• Real Estate Ventures
• All HRs and Es
• People going through divorces
• Georgia
• Autofunding loans listed for a short time period
• People who should be able to get more traditional financing (for something like a car purchase)
• Anyone who has an abnormally low interest rate just because of a really nice looking photo

Anything I am missing on my list? I am sure some loans will still default for me, but just trying to learn from the collective experience out there. (forum post - The official 1 month late loan club...)

Shameless plug here. Prosper just announced a new referral program where they give $25 to both parties when you invite a friend to the program. If you decide to start up you should use this referral link to sign up so that you start of with an extra $25 in your account. Of course, I don't mind the $25 either. :) Details about the referral program.

This referral program reminds me of PayPal. They had amazing growth when they offered a free $5 to both parties when you refered a friend. That's when I signed up. It will be interesting to see how Prosper grows with this new referral program.