It is common knowledge that banks make huge profits on the margin between the interest rates they charge borrowers and the rates they offer to savings account holders.
The sheer size of these institutions allows them to easily diversify among a huge pool of borrowers and account holders, and they have historically had a monopoly on the lending market. Prosper.com, the first major person-to-person lending service in the U.S., intends to change all that by connecting small-time lenders directly with borrowers.
Many investors were intrigued by the idea of replacing banks in the lending equation. “It was a very interesting idea to me,” Kevin Gillett, a Prosper lender and the author of www.rateladder.com, said. “I love the idea of cutting the banks out of the picture.”
Prosper “basically allows me to be the bank, which I really like,” said a Prosper lender who goes by the user name of Technologyguy and authors the site www.lazymanandmoney.com.
Prosper has the advantage of independence from the stock market, “so even if it can’t blow the doors off returns that you might see hyped up about it, if it can return 10 to 12 percent and be orthogonal to the stock market, I think that alone is enough of a reason to invest in it,” Gillett said. Prosper is creating a “completely different asset class,” he said.
On Prosper, the process begins when a borrower posts a loan application that includes a requested dollar amount, maximum interest rate and other credit and personal information. Lenders can then bid on the loan in an auction-style format until the loan is fully funded or the auction time runs out, much like eBay.
Prosper requires just a $50 minimum bid on any single loan, so lenders can diversify their funds across many different loans. A standard $5,000 loan application may end up funded by 100 different lenders. “It’s important that you diversify your loan portfolio, although you clearly would rather find 20 great loans than 70 good ones,” Gillett said.
Certain financial information in a borrower’s application is verified by Prosper, such as credit history, homeowner status and whether the borrower holds a bank account.
Prosper gives each borrower a credit grade based on his or her Experian credit score. Much of the rest of the information contained in a loan application is personal information provided directly by the borrower, with no verification from Prosper.
Lenders vary in the ways they deal with that personal information. Some try to eliminate it completely from consideration and focus solely on the numbers. Technologyguy, for example, disables all images from the site and avoids reading personal information because he doesn’t “want to be subconsciously swayed by a cute smile or a slick writer.”
Some lenders use the personal information as a way to weed out undesirable borrowers. “The personal information that they give is not something I ever use as a mechanism for deciding to bid on a loan,” Gillett said. “What I use it for is a mechanism to not bid on a loan.” When reading borrower listings, Gillett looks for “inconsistencies or any other red flag that might cause me to think they wouldn’t pay.”
It seems that every lender who pays even a little attention to personal stories favors certain types of borrowers over others. Gillett, for example, is drawn to people who are starting a second business while maintaining a steady day job.
A Prosper lender who goes by the name of Ms. Ava said she prefers to lend to those who “have enough money to pay their bills” and who “just need this extra money for a particular situation,” such as a taxi driver wanting to buy his own cab or a truck driver wanting to add a second vehicle. She also likes borrowers who are consolidating debt.
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The main attraction for lenders is the loan’s interest rate; lenders typically seek a high interest rate for the amount of risk the borrower presents. Prosper helps lenders analyze risk levels by providing default rate statistics from Experian for the various credit grades.
Gillett believes that many Prosper borrowers “are not capable of getting loans at other places,” and therefore Prosper’s default rates “are higher than average, for say the Experian data. But it’s unclear what they actually are.”
Comprehensive data on Prosper’s average default rates is not yet available because Prosper is a year-old company offering three-year amortized loans. Prosper makes a wealth of data available on its marketplace performance page, and lenders can elect to receive daily e-mails with the latest statistics.
Gillett carefully analyzes that information and frequently adjusts his lending strategy accordingly. “I’m trying to be cautious and follow what’s going on and track how I’m doing and understand the marketplace,” he said.
Most of Prosper’s 11,500 lenders are seeing competitive returns so far, according to Eric’s Credit Community, a website that analyzes the official data released by Prosper. After adjustments for default risk, 75 percent of all Prosper lenders are seeing a return of more than 10 percent, and 98 percent of lenders are achieving more than 6 percent.
Diversification increases results; of the borrowers with more than 25 loans, 81 percent are seeing returns of more than 10 percent, and 99 percent are achieving more than 6 percent.
Activity on Prosper is reflected in a borrower’s credit history, so borrowers who wish to maintain or improve their credit have an automatic incentive to stay current on their Prosper loans. Borrowers who already have good credit are in high demand.
“The numbers speak for themselves,” Ms. Ava said. “If a person has a history of paying their bills, there’s no reason to think they’re not going to continue that history.” However, borrowers with good credit do not generally offer very competitive returns; their interest rates are bid down quickly at auction.
Prosper also introduces a social networking concept intended to motivate borrowers to make their payments on time. Borrowers and lenders can join groups on Prosper. A group leader founds and organizes the group and may choose to take a cut of the group’s loans.
Ms. Ava became a group leader for what she calls “selfish” reasons; she wanted more direct access to borrowers and their information than she had as a lender. Many borrowers are willing to share information with their group leaders that they would not otherwise share with lenders.
Ms. Ava believes that groups make a person “feel doubly responsible to pay back the loan,” because they don’t want to let the group down. Groups receive starred ratings on a scale of 1 to 5, with 5 being the highest rating.
The quality of groups varies, and the ways in which group leaders verify member information vary widely as well. Ms. Ava said some groups are “totally automatic…the computer does everything.” She conducts interviews with her group applicants and screens them carefully, and she immediately calls any member who misses a payment.
Since the quality of group leaders can vary, some lenders are skeptical of groups. Gillett does not believe that many group leaders “perform the actions that would actually be worth more than what Prosper already provides.” He said he would be influenced by group membership only in cases where the group leader bids on the loan.
Prosper recently introduced an endorsement feature to allow borrowers and lenders to link to friends and family members on Prosper. Friends and family can write endorsements on a borrower’s loan posting, but Technologyguy and Gillett are both skeptical of that feature. They each noted that they would rather see a feature where lenders could receive notifications when their own friends and other trusted lenders placed bids on peer-to-peer loans.
Technologyguy said he would like to see Prosper provide interest on money that sits in a lender’s Prosper account. Right now, he said, he receives no interest on funds that are not invested, and “the money sits around for a long time when it’s being transferred from your bank account into Prosper.”
He said after finding and bidding on a loan, it can take up to yet another month before the loan is fully funded, verified and active. Since the money receives no interest during those waiting periods, “it really cuts into the amount of gains that you can make.” Lenders have the option of bidding manually or automatically through a standing order. Technologyguy said he uses manual bidding 95 percent of the time because he wants to get his money into a loan as quickly as possible to minimize the time it sits in his Prosper account without earning interest.
“Standing orders are good for a different reason,” he said. Some of the best loans get funded very quickly, and “if you don’t have a standing order ready and you’re not logged into Prosper, then you miss out on that opportunity.”
Gillett has relied mainly on standing orders and only recently began to experiment with manual bidding. He said recent changes in Prosper have made standing orders less effective. The problem, he said, is with loans that are not autofunding, which means that “as soon as they’re 100 percent funded, they continue to have the auction open and the bids continue to come in” and the interest rates get driven down.
Gillett said his standing orders “would fire and my money would be tied up in this loan that started off at a great interest rate and then by the time the loan actually closed, I was bid out of the interest rate.”
Manual bidders can search through loans by hand, but Prosper also has “a nice system for saving searches,” Technologyguy said. He uses saved searches to sort through loan opportunities on Prosper. When Gillett’s standing orders became less effective, he began using a saved search, which “is effectively a standing order that doesn’t actually bid,” he said.
In order for standing orders to become effective once again, Gillett said Prosper would need to add “time remaining criteria” in the standing orders.
“eBay has taught us all that the optimal auction strategy is to show up at the last two minutes and outbid everybody and win the listing,” Gillett said. “You weren’t in the loan early, no one knows you’re coming, and…that way, you get the best interest rate possible.”
“The time remaining criteria would allow my standing order to basically act as I’m acting in a manual bid, which is to say, watching the interest rates, watching the loans, and then when the loan gets within 30 minutes of the end of its auction, then to have the standing order fire,” Gillett said. Such a system “is absolutely necessary if you’re going to be a standing order bidder these days,” he said.
Lenders with multiple standing orders face special challenges, Gillett said. He uses five standing orders that build a bid ladder, but “they fire in completely random order and I have no control over the order that they fire in.”
Rather than bidding at the most attractive interest rate first, the orders fire randomly. “So I’d like a little bit more transparent control over when the standing orders fire,” he said.
Overall, Gillett and Technologyguy are positive about Prosper and its future. Gillett would “like to think that my Prosper account would continue to grow and at some point it would always be 5 percent of my portfolio,” or even 5 to 10 percent, he said.
“If I could buy stock in the company,” Technologyguy said, “I would.” He said he considers Prosper “an ideal business.”