How I Became a Little-Guy Lender
I'm conservative with money, so lending to strangers on a Web site called Prosper might seem out of character. But when I was going over my investments this past winter, my well-balanced portfolio of mutual funds wasn't doing so hot, and my once-high-interest savings account seemed less and less appealing as rates kept falling. Since Prosper's founding two and a half years ago, peer-to-peer lending, as it's known, has been gaining respectability, and I liked the idea of helping people to expand businesses or pay off credit cards with exorbitant rates. I figured I could get at least a smidge more income on Prosper than from my boring, reliable bond fund, let alone a savings account, even if—as seemed likely—a loan I made defaulted.
And so, in January, I transferred a few hundred bucks to Prosper. I created a set of rules for what I'd bid on and how I'd structure my mini-portfolio. But even as I started to acquire loans with double-digit interest rates in Prosper's online auctions, I couldn't help asking myself: Was I nuts for thinking I could pick the "right" loans? What made me believe I understood the real risks of bidding on a stranger's debts?
The idea behind Prosper, and a handful of sites like it, is to allow average folks to lend to other average folks strapped for cash. It's lending for the little guy, enabled in large part by technology that allows bite-size payments to be processed online profitably.
The concept dates back to 2005, when Prosper, along with a similar venture in London called Zopa, set up shop. Prosper founder Chris Larsen started the site after selling his previous consumer-lending company, E-Loan, to Banco Popular parent Popular (BPOP) in 2005. (Larsen is one of the good guys of consumer finance: He used his position at E-Loan to push for disclosure of credit scores and analysis to consumers.)
By the time I decided to become a lender, peer-to-peer lending had grown substantially. Prosper's loan volume has surpassed $130 million, and rivals such as Lending Club, Virgin Money USA, and Loanio have gotten in on the action or plan to do so. In the overall $2.5 trillion consumer-credit market, this kind of lending is a flyspeck, but it has the potential to change how lending is done. It's projected to grow fast: Online Banking Report, a monthly publication, has estimated that originations could hit $9 billion by 2017.
For me, there was no question which site I'd pick. Prosper was the leader, and I trusted Larsen, whom I'd spoken with before in the course of writing articles. I'd actually registered with the site years ago and then ignored it, happy as I'd been with my other investments.
Prosper spent years getting regulatory clearance. But for individuals, putting money to work is simple. It works, essentially, like eBay (EBAY). Prosper acts as an intermediary—technically, it makes the loan and resells it to you—and takes a sliver of profit from both sides of the deal. Borrowers list loans, eBay-style, of $1,000 to $25,000 and choose their interest rates. When Prosper was set up, its borrowers faced a patchwork of maximum rates dictated by state usury laws. But FDIC-insured banks aren't subject to state usury rules, so when Prosper partnered with WebBank in April it could permit borrowers to go to a max of 36% in the states in which it's approved, save Texas. (Prosper is not approved in South Dakota.)
A lender bids, in amounts between $50 and $25,000, at rates as high as the posted rate. Say a borrower posts for a loan of $15,000 at 15%. I might bid for $50 of that loan at 12%. I'll get my slice of the loan at 15% if there aren't many bidders. But if the loan gets fully funded and more lenders want it, the rate will be bid down until bidding closes. In that case, if the rate goes below 12%, I'll lose the loan unless I bid again.
Although borrowers and lenders use noms de Internet, there's a bit more due diligence than with eBay. Borrowers allow Prosper to pull credit reports (it assigns each a grade of AA to HR, for high risk, and requires a credit score of at least 520) and verify banking, employment, and homeownership. Lenders see details culled from these anonymous reports, such as debt-to-income ratios and prior defaults.
There are risks, to be sure. The biggest is defaults. Prosper's average net default rate—based on the amount of money that is defaulted after collections—from Nov. 1, 2005, through Apr. 18, 2008, for all credit grades was 4%. That's roughly in line with defaults on credit cards. For high-rated loans, net defaults were below 2%—0.5% for AA, 1.4% for A, and 1.8% for B. The default rate based on the number of loans made was somewhat higher than those net dollar figures: 6.9% overall, with high-rated loans still below 2%.
Of course, past defaults may not have any relationship to future ones. And my handpicked portfolio might do worse than average. Moreover, some lenders grouse that stated default rates don't represent the true risk, given the short time many of Prosper's loans have been on the books.
The second potential problem is liquidity. Prosper loans have three-year terms. While a borrower can repay early with no penalty, a lender can't call a loan in. Prosper is working with regulators to set up a secondary market, but for now there's no resale option.
My first loan was to a bakery in Texas, and I got to feel like an angel investor for $100. After a little obsessive Googling of the borrower's Prosper user name, I found a blog where the owners were blabbing about their problems and all the things they'd done wrong. If I'd seen it before bidding, I would have steered clear. Thankfully they paid me back in full a month later.
As I got more comfortable lending, I ponied up until I hit $1,500, an amount large enough for diversification but small enough that if something went wrong I wouldn't be sunk. I've now lent to students scraping together tuition, families consolidating credit-card debts, entrepreneurs expanding, people hit by major medical costs, and a guy buying an engagement ring. To keep risks down, I've targeted borrowers rated AA, A, and B, kept my loans in the $50 to $100 range, and forced myself to ignore incessant e-mails Prosper sends when you're outbid on a loan. I often ask borrowers for additional information.
In April, one of my 27 loans paid late, but the situation was rectified within days. Then, on Apr. 7, Prosper's chief rival, Lending Club, stopped allowing new lenders to register and existing ones to make new loans. It noted in a statement that it had "started a process to register, with the appropriate securities authorities, promissory notes that may be offered and sold to lenders through our site in the future." Most promissory notes must be registered with the Securities & Exchange Commission and the states in which they're sold, unless they qualify for an exemption. Peer-to-peer lending is so new that regulatory requirements aren't entirely clear, but a Prosper spokesperson said the company believed it was in compliance with all regulations. Prosper filed a registration statement for its secondary market with the SEC in October.
So far, as long as you discount the hours it has taken to set up my mini-portfolio, I'm doing O.K. In fact, these days, Prosper is one of the few bright spots in my portfolio. As of mid-April, my average interest rate was 13.65%, and all my loans were current on their payments. I seemed, at last, to have things running on autopilot, so I no longer need to log on every day, scroll through listings, and bid. If the loans keep paying, it might—just might—be worth it for more than the satisfaction of lending a helping hand.