A first look at Prosper

Would you like to earn a great return on your money with minimal effort on your part? I mean, come on, who doesn’t want to get paid for doing nothing?

My wife and I already have a dividend growth portfolio that we’re building, but if you’re like me, you probably intend to get into in several different investment vehicles. For us, we’re looking to get into real estate in the next couple of years.

In the meantime, I try to keep my eyes open for different opportunities and ways to make money that can provide us with a decent return without requiring the capital that you need to get started in real estate. Recently, I’ve heard more about peer lending and decided I wanted to look into it.

What is Peer-to-Peer Lending?

Peer to peer lending is like crowdfunding for loans and financing.

From the borrower’s side, a peer lending platform will let people borrow money from strangers like you instead of from a bank.

This can be a good option for people who are looking for better financing terms for their debt, for people who have maxed out the credit available to them and need another option, or for those who can’t qualify for traditional financing for whatever reason.

From the investor side, peer lending is a way to earn a better return than they would be able to find in most savings accounts, money market accounts, certificates of deposit, or some bond funds and annuities. If you invest in your money with a peer lending platform you’ve essentially become the bank for someone else.

Sounds like a win-win, right?

Sadly, most peer-to-peer lending platforms require you to be an accredited investor. I poked around a bit, and the two peer lending platforms I found that didn’t require you to be an accredited investor are Lending Club and Prosper Lending.

For this article, I’ll be looking in depth at Prosper Lending, and if I ever feel like it, I may do the same for Lending Club.

About Prosper Lending

Prosper was founded in 2005, is headquartered in San Francisco, and claims to be the first peer lending platform. But before I get into the details of investing in Prosper loans, there are a few other things I think you should know about Prosper.

First, back in 2008 the SEC determined that Prosper had violated the Securities Act of 1933 and ordered them to shut down. The SEC did this because it classed the sale of Prosper’s debt notes to investors as a securities sale, and Prosper was not registered to sell securities to investors.

Prosper restructured their business model, and were allowed to resume business in 2009. Under their new terms Prosper itself is considered the obligated party for their notes.

In other words, if you invest in their loans, Prosper itself owes you, not the original borrowers. The original borrowers are classed as creditors to Prosper. In essence, Prosper has stepped between you and the borrower so that they can comply with SEC regulations.

The second thing you should know about Prosper is how their investment process works.

Since their founding, Prosper has originated over $9 billion in loans, typically with fixed terms of 3 years or 5 years. Their minimum loan value is $2000, and the maximum loan value Prosper offers is $35,000. Prosper charges a 1%-5% origination fee to its borrowers, depending on their risk class, and a 1% annual servicing fee to investors.

Prosper classifies their loans as AA, A, B, C, D, E, and HR, with the loans they determine have the lowest risk classified as AA and going on down to HR, which stands for High Risk. For both the borrowers and investors, the yield on the loans is determined by their risk class.

In addition to their risk class, Prosper also allows you to view additional information about their borrowers, including their credit score, occupation, income, and parts of their credit history.

Prosper allows investors to buy chunks of each of their notes in $25 pieces and recommends that you buy a large portfolio of $25 chunks so that your risk is spread out between several different borrowers. Instead of one investor holding the entire amount of a $5,000 loan, you might end up with 200 investors each owning one $25 segment of the $5000 loan.

After a loan is originated, its tracked in your dashboard and you receive a monthly interest payment until the principal is paid off.

I’ve heard a wide variety of recommendations, but it seems that the general consensus among the investor community is that you should invest a minimum of $2500 and spread yourself between 100 different notes in order to make Prosper worth your time as an investor.

Why You Should Invest in Prosper Loans

Alright, now let’s get to the fun stuff. Why should you invest in Prosper notes?

For one, Prosper notes provide you with a way to diversify your investments. Instead of investing in stocks or traditional bonds, you are essentially purchasing individual bonds from Prosper, the repayment of which is contingent upon debt payments Prosper receives. (Yeah, you’re not actually buying the note. Remember what I said earlier about how Prosper is structured since its relaunch.)

Another good thing about being an investor is the return you’re earning. According to Prosper, the average investor earns an 8.01% return on their investment. Taken directly from their website, this is how they calculate that average:

“Estimated returns are calculated by (i) taking the weighted average borrower interest rate for all loans originated during the period, adding (ii) estimated collected late fees and post charge-off principal recovery for such loans, and subtracting (iii) the servicing fee, estimated uncollected interest on charge-offs and estimated principal loss on charge-offs from such loans. The actual return on any Note depends on the prepayment and delinquency pattern of the loan underlying each Note, which is highly uncertain. Individual results may vary and projections can change. Past performance is no guarantee of future results and the information presented is not intended to be investment advice or a guarantee about the performance of any Note. Based on data from May 1, 2017 – May 31, 2017.”

Which is to say that your return might vary from the average, and is highly dependent on the kind of loans you choose to invest in. Prosper provides the following estimated returns for each loan class:

AA: 4.2%

A: 4.81%

B: 5.53%

C: 7.72%

D: 11.08%

E: 13.17%

HR: 11.65%

Essentially, prosper estimates that if you invested only in B grade loans, for example, you would end up earning 5.53% on your investment, after fees and loan defaults are factored in.

In addition to your return, one good reason to invest in Prosper is that you’ll receive a monthly income in the form of interest payments on your investment and have a (sort of) guaranteed return of principal after all is said and done.

If you have a pile of cash sitting around, this might be a good way to make sure you beat inflation, and it sure kicks the pants out of most CD’s available today.

Another attractive benefit from investing in peer lending products like those Prosper offers is that you can select your own loans based on whatever metrics you choose to focus on. If you have a high risk tolerance, you’re free to invest in high risk loans. If you have a low risk tolerance, you can protect your principal by selecting AA and A grade loans.

You’re also able to set up an automatic investment based on the criteria you select. Prosper will then buy loans that match your criteria as they become available, until you no longer have capital in your account.

Why You Shouldn’t Invest in Prosper Loans

Okay, now that we’ve covered a few of the reasons why you should invest in Prosper loans, let’s go over a few reasons you shouldn’t.

First off, you really shouldn’t invest in Prosper if you’re going to need money soon. Like I said, Prosper offers notes that are in 3-year and 5-year denominations, so if you know you’ll need a chunk of change anytime in the near future Prosper is not the place for you.

Prosper used to allow investors to sell their notes on a secondary market, but that service was shut down at the end of 2016 and hasn’t been reintroduced. That means if you buy a note from Prosper you have to hold your note to maturity, so if you’re looking to have liquidity in your investments I would suggest you go with something else.

Another reason you shouldn’t invest in Prosper is that you don’t actually own any portion of the note you’ve invested in. The fact that you’re buying a bond from Prosper means that the borrower who owes the loan you “invested” in has no legal obligation to pay you back. Instead, Prosper owes the loan and has complete control over what action to take if it defaults. If they want to sell it off and you, personally, would rather keep it, you get no say.

Investing in Prosper means you’re sacrificing control over your investment.

For that matter, if Prosper itself declares bankruptcy you’re out of luck when it comes to getting your money back. There will be a long line of creditors in front of you, so you’ll end up losing your principal and the interest you’ve earned.

That means that if you decide to invest in a Prosper loan you have to be comfortable with Prosper’s long-term prospects, not just the likelihood that the loan you bought will repay.

Prosper has attempted to mitigate this risk by creating two legal entities, one called Prosper Funding, and one called Prosper Marketplace. However, since Prosper Funding is a subsidiary of Prosper Marketplace they haven’t really solved the problem. If Prosper Marketplace declares bankruptcy Prosper Funding is a viable source for creditors to reclaim their capital, and Prosper Marketplace will be a likely source to recoup losses if Prosper Funding goes belly-up

Another reason you shouldn’t invest in Prosper is that some of your loans will default, meaning a loss of principal and interest gains. If this happens to you, and it will eventually, you need to have enough of a return on your other notes to cover your loss or you’ll end up earning a negative return.

If you’re not comfortable with the idea of losing some of your money to defaults you need to go somewhere else to invest. Stocks, for example, are far less likely to completely wipe out your principal without giving you an option to get out and preserve at least some of your investment.

The Bottom Line on Prosper

Having gone over a few of the reasons why you should and shouldn’t invest in Prosper loans, let me finish off by saying a few things.

I think Prosper can be a good investment for you.

If you understand the risks and you’re comfortable accepting them there’s an opportunity to make a great return through Prosper. I wouldn’t recommend you put your life savings into Prosper, but it would be a great supplementary investment to help you earn an above average return on your additional capital.

Every investment carries risk, and Prosper is no different. If you’re not willing to risk anything you’ll inevitably lose when it comes to money. That said, that doesn’t mean this investment is the one you should take a risk on.

I also think that Prosper can be a terrible investment for you.

If you’re the kind of person who gets caught up in get rich quick schemes, Prosper’s probably a great place to lose your money. Especially if you decide this is your chance to make it big and sink your life savings into it.

If you get greedy when you see a loan with a 24.99% interest rate, you’ll probably make sub-par investment decisions and destroy your returns. You need to take a disciplined approach to investing, and I don’t think Prosper is the best place to develop that approach.

Lastly, for those of you who are interested in investing in Prosper, I’ve created an Excel spreadsheet where I’ve run some analysis on every Prospers loan since their inception in 2005. Be warned, it’s pretty big. Since 2005, they’ve issued 710,212 loans and had 58,693 defaults. I’ve summarized those defaults by loan amount, interest rate, and credit rating and run a basic statistical regression.

I’d like to come up with a predictive model, where you can plug in those variables and decide if the risk of default is acceptable to you, but I’m still working on it and didn’t want to delay this post any longer. I’ll give you an update here when I finish it.

If you have any questions for me as you’re reading through the spreadsheet, please get in contact with me.

To finish up, I’m curious. Do you have any experience with peer lending? If so, what are some of the benefits to investing in peer loans, and what are some of the risks that I missed?

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