I hope you are all enjoying Prosper Week. Today we are going to look at my lending past. This is ideal timing because I currently have made 98 loans (and with 9 pending verification, it could be 100 by the time you read this). Also, my first loan is a year old.

That first loan is very interesting in that shows where I started. It is a C grade credit score with a 19% debt to income (DTI) ratio. I’m making a whopping 12% interest rate on the $100 investment. All the Prosper lenders reading this right now are probably cringing. I don’t know why I put $100 in my first bid. It gave me no diversity at all. More importantly, I needed to get a higher grade or a higher return. Nowadays, I have to think twice before bidding on a C loan at 20%.

I took two months before placing my next loan on Prosper. I didn’t have the spare income to devote. When I did put in another $200 in my account I made a $50 loan and then bumped it up to $100 again. At least this second $100 went to a C grade borrower with a 10% DTI at a 23% interest rate. Happily both of my $100 loans are current today. From there I made a pretty silly, but entirely reasonable assumption given the data available to me. I calculated that my actual interest rate was the rate of the loan minus the expected default percentage. So as long as that number was high, say over 15%, I put money there. It hurts for me to even look back on those days.

It only got worse from there. I had been introduced to Eric’s Credit Community. There they have rankings of diversified (25+ loans) lenders sorted by expected return (a monstrously long page, that you can get here, if it doesn’t crash your browser). I realized that if I bid on E grade loans with a 29% interest rate, my number at Eric’s CC would be higher. It didn’t matter if the DTIs were over 100%. I was climbing up the charts and it sure felt good. I’m still in the top 50 on that list.

Now if you’ve been reading the other posts this week, you’ll be aware of Jonathan’s analysis. It’s worth looking at the E rated loans which have -9% interest rate return. This is disastrous on every level.

I’ve turned a corner and tomorrow, I’ll show you how I did it.

(Jonathan at My Money Blog has a very in-depth two part review of Prosper.com. My Money Blog is one of my favorite sites, which is why it’s in my blog roll and feed reader. It’s worth familiarizing yourself with that article before continuing here with my rebuttals.)

Jonathan notes that there are significant times where your money is not getting invested, possibly eating 1-2% of the ROI. The time that money goes “uninvested” is one of my biggest pet peeves and while it does seem like an eternity, I’ve never seen my money take more than 30 days to get invested. Once the money is invested, it’s invested for 3 years or (1095 days). In that light, I’m not sure how significant 30 days is. It looks to me to be 2.7% of the 9-10% ROI, thus you’d still make 8.76-9.73%. It’s unfortunate that the money is not earning any interest during those 30 days, but I’m not sure it’s completely disastrous to the return. My math may be faulty here, so please correct me if I’m wrong.

“Another slight concern is prepayment risk, when a borrower pays off the loan ahead of time. For example, interest rates might drop, and the borrower may find a better deal elsewhere. Even though you can reinvest the money, you’re still facing the extra lag time to find another listing, bid on it, pass review, and fund.”
a) This is a valid concern, but it’s rare. Thus far of the 95 loans I’ve had, only two have been repaid early. Some of those are new, so it’s probably too early to tell what my real percentage will be. It’s worth noting that when this occurs there’s zero chance at a loss of principle. It happens so rarely that only if I make 1% on these loans, I don’t mind.
b) On the other end of the spectrum, there are people who are chronically late with their payments, but keep paying. This leads to a situation where the loan might be extended over the 3 year time period. Taking one of my loans as an example, one borrower has made three payments since October, 2006. Each of these have been late and are interest only payments – no money has gone to pay of the principle. In total the borrower has paid off only $2.70 in principle, but has paid me $6.50 in interest. I would prefer he’d pay on time as it feels wrong to continually collect interest like this, but it’s not my say – it’s entirely up to the borrower.

“It’s far too much work” – While I’m quoting Jonathan, I’ve read this many, many times.
a) While some find it “fun,” let’s assume that you are one of the people that find Prosper as “work.” How much time you spend on Prosper is entirely up to you. The return and success or failure you have there is not related to the time spent. The advanced search that Prosper provides users a way to filter the loans that would never be right for them. Using that tool, my typical Prosper session is probably about 5 minutes, maybe less. I tend to sign every other day and not much on the weekend. So that’s about 3 times a week for 5 minutes — 15 minutes of time spent a week. I’m a Lazy Man – I even put it in the URL – but even I’m not that lazy. Why is it quick for me? I try to avoid the stories – Jonathan put it best, “I’d personally rather not be emotionally invested in my lending.”
b) Prosper also something called the standing order. The standing order is a set of loan conditions set by the lender, which, if met, will trigger a bid placement. I have some standing orders set up, so that if someone with A credit, with good debt-to-income, and few delinquencies, wants to borrow money at 20% interest, it will place a bid. I don’t even need to be around. Prosper could be working for me while I’m out of the country, on a beach. There are a couple of downsides to this. If someone says they are building a bomb with the money, I can’t retract my bid – I’m stuck. No one has said that though, so thus far I’m fine with this. The other drawback is that I have leave some money in the account to get these great loans. I generally try to leave just enough money to get one of them a day – around $50. So that $50 doesn’t earn interest while it’s waiting, but I had go into some great loans with this tactic. I missed on last week because I didn’t have the spare $50 lying around.
c) On Friday, I’ll go into more depth about how I quickly make loans.

(Jonathan at My Money Blog has a very in-depth two part review of Prosper.com. My Money Blog is one of my favorite sites, which is why it’s in my blog roll and feed reader. It’s worth familiarizing yourself with that article before continuing here with my rebuttals.)

1) “It’s not a short-term, safe investment” – Jonathan mentions an advertisement for Prosper (presumably from them) paints their returns favorable light to some online banks. I have not seen this advertisement, but if Prosper is the source, it’s an unfortunate misstep by their marketing department. It’s not comparable to bank interest. Since there is the possible loss of principle, it is best looked at as being similar to a mutual fund. Like a mutual fund, risk is managed by diversifying the investment in lots of small places. Prosper even recommends diversifying your loans to lenders. It’s worth noting that mutual funds aren’t short-term, safe investments either, but that doesn’t make them bad.

2) Other ways to get higher interest for extra risk – Jonathan mentions other ways to get 13-15% returns with extra risk. I’m personally making 24.32% gross, but when adjusted for risk, I’m making anywhere from 12-16%. (We’ll talk more about this calculation on Friday.) Some of the other ways didn’t seem like the best ideas either which may be why Jonathan doesn’t recommend them. Investing in PGH (a Canadian Oil Trust) or LUM (a REIT stock) is simply not very diversified. You are basically betting on one segment of the market. Accounting errors or investigations in a stock could make your invest worthless in seconds (remember Enron). The same thing could happen to Prosper, but even in bankruptcy protection, your investment would be safe from those accounting errors in Prosper. You simply aren’t relying on one corporate structure.

3) In looking at Prosper as an investment in general, Jonathan says the results are “Not so good…” He may be right, but it depends on the viewpoint. For instance, he says, “it seems that lenders as whole did a horrible job pricing the sub-sub-prime market. Sure, they charged them a fat 25% interest rate, but the default rate was so high that the net average return on an HR loan was -21% to -31%?!?! Ouch.”

Towards this point, lenders would have charged more, but most states’ usury laws make the highest possible rate 29%, with some states much lower. Thus lenders’ only other choice was to not lend to these people. That’s a valid point, but a lot of lenders didn’t know better. Prosper, for its part, does put up a warning window to lenders when they try to loan to someone with E or HR credit. Indeed some lenders still loaned them money, but a lot of people bought a Pet Rock as well. Not everyone is the sharpest knife in the drawer.

Some of these HR loans are no longer available. As of February 12, Prosper changed the definition of what it considered E and HR… “AA-D credit grades remain the same. E and HR credit grades have changed: E is now 560-599, and HR is now 520-559. NC (No credit) and credit scores lower than 520 are no longer able to create listings.” Looking at This blog post E used to be 540-599 and HR was 300 to 539. As you can see the average E score was about 570 (rounded) and is now 580 (rounded). The average HR score is now 540 (rounded), while it used to be 420 (rounded). That’s a huge change in HR and a bit of a change for E ratings. I’m still not lending to HR, but the \sub-sub-prime loans that Jonathan were worried about are no longer served by the Prosper marketplace.

4) “I’ve seen a lot of people recommend diversifying their credit pool to include everything from AA to a few HR borrowers. If people lent an equal amount of money to each of the seven grades, their aggregate return would have been a measly 2% – not exactly inspiring.” This 2% number is brought way, way down by the inclusion of the HR loans that no longer exist (see previous point). If you just use the AA-HR today your range is Experian ScoreX 900-520, which compares very closely with the AA to E (900-520) of the past. Doing that comparison gives you a 6% return. It’s still not great, but it’s better than you can currently get in a high-interest bank. Using this data, it’s easy to see that diversifying between A-D grades gives you a return of 9+%. If you are thinking of becoming a Prosper lender, it doesn’t take a lot study or discipline to get that 9+%. Simply avoiding the letters E and HR and you’ll be fine – on average. To Jonathan’s credit he mentions this, “On the positive side, the AA through C credit range seems to be the better bet, giving net returns around 10%.”

(Jonathan at My Money Blog has a very in-depth two part review of Prosper.com. My Money Blog is one of my favorite sites, which is why it’s in my blog roll and feed reader. It’s worth familiarizing yourself with that article before continuing here with my rebuttals.)

At a couple of points, Jonathan mentions the prospect of Prosper (try saying “prospect of Prosper” 5 times fast) going out of business. DINKs Finance has mentioned this before. In James and Miel’s analysis, Prosper needs to be making a minimum of $560K while they were only at $380K. They determine from the conservative estimates that Prosper “would be starting to make a profit once they reach the $30M mark in loans.” Prosper passed the $30M some time ago. Prosper are now making $800K a year according to Jonathan’s analysis.

I’d say that James and Miel are very conservative with their estimates. In San Francisco the salaries are probably double the $50K suggestion and cost at least 1M a year, so I suspect there is a still a deficit. If there were ever a money crunch they would only need to employ enough people to keep the servers up and running. The business model is that of a market maker – they ship no product and carry no inventory. They don’t need warehouses and can scale by adding more central servers. Pets.com, Kozmo.com, and Webvan.com couldn’t claim that. You don’t need a business degree to realize that this is one of the most efficient businesses imaginable. In addition, Prosper has no competitors in the US (Zopa is supposedly coming at some point).

If we were to assume that Prosper still have $200K yearly burn rate from payroll and other experiences, it’s worth figuring out how long they can last before they’d go out of business. According to Prosper’s own website they are “Prosper has raised approximately $20 million.”. Using a third party source we find that Prosper “has raised about $12 million in a second round of funding… Prosper’s funding comes after a $7.5 million first round a year ago. Fidelity Ventures led round, which included existing investors Accel Partners and Benchmark Capital. Omidyar Network also came in as a new investor.” Hmmm, so that’s nearly 20M spread over a 200K a year burn rate, which gives them… nearly 100 years before they go out of business. I’m sure that some of that money has been spent already, so maybe they only 75 years left.

Let’s go back and look at the Prosper’s growth. When DINKs Finance had posted, Prosper had only an estimated $380K revenue. Five months later My Money Blog estimates that they have $800K – more than double. It may be hard to continue that huge growth rate, but I haven’t seen a sign of slowing down. Is it still growing? According to the Prosper Developer APIs, they have $45.5M as of 3/20, just 18 days after Jonathan used the $40M number. So suddenly instead of having a burn rate of 1M-800K (or 200K) it’s 1M-900K (or 100K). With the burn rate cut even further they can now last for over 125 years. Looking at the numbers, they should be profitable by May.

The more I look at it, betting that Prosper goes out business is like betting that the Yankees don’t win a game this year. Both are possible, but no one would take those bets.

Even though I just finished making the huge argument why Prosper won’t go out of business, it’s worth noting that lenders get the promissory note for each loan. The borrowers are directly in debt to the lenders. Yes, it would be impractical to go get $50 from 100 different accounts across the country, but you should be able to do so if necessary.

For the rest of this week, I’m going to focus on peer-to-peer lending via Prosper.com. I think I just heard a groan from most of my readers. Please stick with me, there’s lots beyond Prosper.com itself. Why put a week into Prosper.com? Simple because I believe it is the best investment opportunity available to the average person today.

As for a general outline of the week’s posts, here’s what I have planned:

• Tuesday – In Defense of Prosper.com – Can Prosper Survive?
• Wednesday – In Defense of Prosper.com – A Look at the Investment
• Wednesday – In Defense of Prosper.com – Other Common Complaints Rebutted
• Thursday – Prosper Mistakes I’ve Made
• Friday – My Current Prosper Lending – The Keys to Prosper Success

Friday is going to be the equivalent of the “big reveal” of an extreme makeover show. If you’ve ever lent on Prosper or even thought about lending on Prosper, you can’t miss it.