If you’ve spent any time in the archives or if you are a long time reader, you’ll know that I used to write about Prosper.com quite often. I’ve since taken this blog in a more general finance direction. However, I find that I need to continue to cover the peer-to-peer lending space since it’s quite possibly the most new and exciting thing to hit personal finance in some time.

First up, Prosper launched their own blog last week. I had the opportunity to talk with their Chief Marketing Officer more than six months and made this suggestion. I’d like to say that I’m the reason it got off the ground, but I imagine it might have more to do with Lending Club’s Blog. The bigger news, at least for readers of this site, is that I’m writing for Prosper’s blog. In fact you can read my first article about multiple income streams which came out today.

Now that I’ve firmly established the bias I have for Prosper and peer-to-peer lending in general, I’d like to highlight the other side of the story. Free Money Finance decides that investing in Prosper isn’t for him. Here are the reasons he’s highlighted:

1. Stock index funds will average about 10% return over the long-term. That’s roughly what Prosper loans earn too — at best. It could be 1% lower. And we all know that over a couple decades, that 1% can make a really big difference in your total investment return.
2. The Prosper loans take a lot of time to select and manage — at least more than index funds do. The latter are easy, especially when you set up your investments automatically.
3. Index funds seem less risky. It’s not that stocks are without risk, but do I really want to lend money to someone who can’t get a loan from a bank? Think about it — people who do this professionally (bankers) have said this person is a bad risk. So why do I want to give them money.

I’ve read these reasons before and on the surface they make a very convincing argument. However, when dig under the surface some of these are not 100% true for all Prosper loans. I’ll give counter points in order:

1. It’s very tempting to take the average Prosper loan as what your performance would be. When we talk of the stock market it’s been documented that monkeys throwing darts at stocks don’t beat the average performance. However, when you are evaluating Prosper loans, this isn’t really the case. You don’t have to settle for average if you read my keys to Prosper success.
2. Prosper loans don’t necessarily have to take any time to manage. I can go months or years without logging into my account, yet my money can be invested on a regular basis. You simply set up automatic withdrawals from your bank and then set up standing orders to bid on quality loans. Another alternative to this to take Prosper’s portfolio plans which earn up to 11.56%. Who wouldn’t mind that, especially with no work attached?
3. I’m not sure how index funds seem less risky. The assumption with this one is that someone on Prosper can’t get a loan from a bank. I never understood this assumption, but perhaps someone will explain it to me in the comments. I personally would rather not deal with a bank, if there’s a choice of going online. It’s similar to buying a stock through an online broker vs. the traditional way of calling up a stock broker. The old way takes longer, costs more, and is simply less convenient.

In the end, I don’t see how peer-to-peer lending doesn’t win. If you think about banks, they are happy to give you somewhere from 1 to 4.5% interest on your money so that they can lend it out to people at rates that are often more than 12% or 15% – even if you have very good credit. The banker collects that fee of 8-10% for his work. Peer-to-peer lending comes along and says, “We want 2% of that banker’s cut and will give you the rest for doing his job of evaluating risk. Oh and if you want we’ll help you evaluate risk by allowing you to invest in historically good loans.” That sounds like a disruptive industry if you ask me.

Prosper.com released a few new features recently. These features might be interesting to all lenders or potential lenders. Here’s a run down on some of the new features and how they could affect Prosper’s peer-to-peer lending market.

Portfolio Plans – Prosper now provides an automated method to bid on set portfolios. You can choose from 4 model portfolios that range from conservative (estimated return of 8.37%) to aggressive (estimated return of 11.06%). Prosper uses data from over a year of loans to determine the estimated return. I’m not sure if that sample size is large enough to depend on, but it might be interesting to try. This reminds me of some of the options I saw in many 529 college savings plans. I think this has two obvious advantages for lenders.

• It could be an attractive option if they don’t wish to spend hours reading and bidding individual profiles.
• It also gives guidance to those that might want to just diversify their investments outside of mutual funds. If you don’t care to learn the skill of finding quality loans, simply set up an automated bank transfer, choose a portfolio plan, and be lazy.

0% Fees on AA Loans – This is pretty big for those looking to place conservative loans. You already knew that low fees are good for other investments like mutual funds. The same concept applies here.

Interest Rate Cap is Increased to 36% – It was previously capped at 30%. I had difficulty making money with some lower grades even at 29%. In fact, I lost significant money on those types of loans. Perhaps at 36% it is possible for lenders to make money on loans from borrowers with lower credit grades.

Guidance on bidding – When you place a bid, Prosper attempts to calculate the estimated return. This is extremely helpful I found that some of my standing orders placed a couple of interesting recent bids. I thought that getting 18% from a B grade borrow with low DTI and low delinquencies would yield a pretty return. It seems like there were too many credit inquiries in the last 6 months reducing my estimated return on this potential loan to around 4%. Now if only there was a way of placing bids based on these estimated returns. Prosper, please allow me to set up a standing order for anything that has a 12+% estimated return. I know this is close to the aggressive Portfolio Plan, but this would give more diversity to the lending.

Now might be one of the best times to lend money on Prosper.com. For more on the changes, you might want to read this post on RateLadder.com.

For a large part of this year, I have been regularly adding money to my Prosper account. I’ve enjoyed lending money to other people and I think I’ve done fairly well making money. I stress the “think” because it can be difficult to quantify exactly. On average, I seem to be making around 7% there. I would be doing much better if I didn’t make some poor decisions early on taking on too much risk.

So why am I stopping my contributions? I looked at my 401k contributions for this year, and though I’ve stepped it up significantly over the last month, I’m still further behind than I’d like to be. I spent a large part of the year saving for the wedding, so I have a lot of catch-up. If I’m going to meet my goal of contributing the full amount for the year, I’m going to have to make some cuts.

Along with the 401k goal, I have is to finish paying off my HELOC. I set it up nearly two years ago to pay for the ring to ask my wife to marry me. I then did something a little unorthodox and used some of the funds to temporarily allow me to live while I maxed out my 401k plan back then. I wouldn’t recommend that course of action, but I should explain why I did it. At the time, I could borrow money from the HELOC at around 6% after tax deductions. I calculate that my 401k will make 9% over the long term. That’s around a 3% gain in my pocket. Lastly, I figured this would be tremendous motivation for me to live frugally. It was very much a forced savings plan.

Today that HELOC is a burden that I want to be free of. I’m no longer able to deduct the taxes which means that I pay more in interest than I used to. I’ve made some great strides in paying it off over the last couple of months, but it’s time to double the efforts.

I’d like to invest more in Prosper. It’s still new and exciting to me. However, sometimes you have to go with the boring mainstays such as investing in a retirement plan and playing down debt. I won’t eliminate loaning on Prosper completely, I’ll continue to reinvest the payments that borrowers make into new loans. Maybe by the start of next year, I can begin again without having to worry about saving money for a wedding or a wedding ring.

“Prosper beats the S&P 500” – That’s the subject heading from an e-mail that appeared in my in box last night. If that surprises you it probably should. It surprised me and I support the company more than most people. However, there’s a graph and everything so it must be true, right?

I looked a little more into where the graph numbers come from. For some reason they decided to compare the average return of the S&P 500 over the last two years (from 8/16/05 to 8/16/07). It’s worth noting that the S&P was at a 3-month low on 8/16/2007. They compare that against the returns of Prosper for one year. Why one year of Prosper vs. two years of S&P? I don’t know. They could have just done one year of each, but my guess is that didn’t look so well for Prosper.

So where does the 9.20% they advertise come from? One might naturally assume that all loans do. However, Prosper chose only a small subset of loans they offer – specifically the loans that beat the S&P 500 are those “originated between 7/22/06 and 7/22/07 to borrowers with AA credit grades who have 0 delinquencies and 0 to 2 credit inquiries on the their credit record, as of 8/23/07.” They provide a handy link to the Prosper performance data over the last year. Looking at it, it seems like AA, A, and B loans all perform as advertised, but C, D, and especially E are far below the S&P 500. Grade E loans lose 8% on average.

While it seems that Prosper is doing a bit of cherry-picking here, perhaps we shouldn’t fault them for it. After all, each lender can cherry-pick the people they lend money to on Prosper. If the average AA, A, or B loan earns over 9%, then if you can pick better than average loans you can do better. This is why I recommend that you review my keys to Prosper to Success. With no time investment at all, you can be getting several points above that average.

So while I think Prosper’s marketing tactics can be a little deceptive, I think it has a place in one’s portfolio. With people getting scared out of the US markets, a Prosper portfolio seems like a good hedge.