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This is the 3rd post in a series of articles about Prosper.com. Prosper is a person to person lending site with an auction format similar to EBay. If you’re a lender you may want to consider the risks of lending money on Prosper before you start loaning money.

In my previous article on Prosper, I discussed how Prosper.com works. Refer to that article for details about Prosper. This article discusses the risks a lender assumes by loaning money on Prosper.

Seeking Higher Returns

If you’re like me, you not satisfied with the low returns you get on traditional savings accounts and CDs. I’m a saver, but saving today just doesn’t pay very well. You always have to search for new opportunities for a higher rate of return.

Inflation Risk

Saving accounts and other FDIC insured accounts carry very low risk. If you follow some basic rules there is almost no chance that you will lose your money in an FDIC insured savings account or CD.

The major risk you face is inflation. Inflation is raging out of control. The latest figures I’ve seen indicate inflation is between 3 and 4 percent. Inflation easily eats up any returns you get from even the new high interest online savings accounts. Just go to the gas station or the grocery store and you can see the effects of inflation.

Inflation risk is one of the factors that motivated me to try Prosper.

Diversification

A key to wealth building is mitigating (reducing) risk. One way to do this is proper asset allocation. You don’t want all your eggs in one basket. That’s why I wanted to try Prosper.com. I already have investments in stocks and bonds and I consider my house an investment in real estate. I wanted a different asset class to diversify my portfolio.

So now the risks that I was trying to avoid with Prosper but what about the risks I was talking about earlier? I’ll outline the risks of lending with Prosper below.

Fees

This isn’t exactly a risk, but it’s something you should know about. Prosper takes 1 percentage point of interest as a servicing fee. Prosper is up front with this fee and lists it right on the bidding page. Prosper will deduct the fee (along with other expenses listed below) and display an expected rate of return. Fees aren’t a showstopper but you should be aware of them.

Your Money is Tied Up for 3 Years

This can be good or bad depending on how you look at it. If your loan stays current for the whole period of your loan (the borrower keeps making payments) you will receive a nice return on your investment.

The Good

Having your money earn a solid return for 3 years is good. Its good for the same reason banks like loans and mortgages. Why?

A steady stream of income into the future has a real value. There are a few formulas that will tell you the present value of a future stream of payments. The bank knows how much it’s worth every day based on its outstanding loans and its deposits. Having a regular source of income every month is a very good thing.

The Bad

If you need your money right now, you can’t get it. There is no way to cash out a loan in Prosper.com. Make sure you read that again and understand it: there is no way to get your money out of a Prosper loan. You simply have to wait until it’s paid off. This point leads us to our next risk.

There is No Way to “Cash Out”

Almost every other financial instrument allows you to cash out. You can sell stocks, you can redeem a CD (with penalties), you can cash out your Roth (penalties may apply) and even your 401(k) (you guessed it, penalties). So even though you will have to forfeit some of the gain and even pay taxes, you can get your money. Not so with Prosper.

There was some talk about Prosper creating a “secondary market.” However, as far as I know those plans have fallen through. A secondary market is just a technical name for the ability to resell loans. So if you need your money, you could sell your loans to someone else. A buyer might pay you less than the loans are worth but at least you could get a portion of your principle back.

You Could Lose it All

That’s right; you could lose 100% of your investment. In fact, you can calculate the probability of the borrower not paying the money back. Prosper publicly lists it loan performance stats. You can find it in the article links below. The stats show that someone with AA credit has a .72% (less than one percent) chance of defaulting. While someone with an HR rating (the lowest) has almost a 23% chance of defaulting.

Banks know that some people don’t repay their loans for whatever reason. This is one of the costs of doing business. This is often called something like bad debt expense. Actually anyone in the loan business, including businesses who sell product based on credit will have bad debt expense. Odds are that someone will not pay.

To Prosper’s credit, they now include an allowance for bad debt expense in your calculated return when you bid on a loan. This can be very helpful when determining your actual rate of return.

Higher Returns, Higher Risk

If you want to make more money, you’ll have to take on higher risk loans. Of course, at some point, this just won’t pay as you can’t charge somebody for their real risk because of state usury laws.

What this means is that it’s probably wise to avoid HR loans because you can’t charge enough interest to offset the risk.

Conclusion

Loaning money will always be risky. It doesn’t matter if you are a nationwide bank or just a person with a few extra bucks and an internet connection. People don’t repay loans for a large variety of reasons. Before you start lending money, whether it’s on prosper or to your cousin Fred, keep in mind that you might not get the money back.

The Prosper performance page just shows you the averages. If you owned all the loans in prospers portfolio, you could expect that average and that rate of return. However, your results will vary. In the next article I will detail my actual performance results with Prosper.com.

Article Links

Prosper.com Performance Stats

Tags    Investing    Loans    p2p    Peer to Peer Lending    Person to Person Loans    Prosper    Risk

Related Posts

• Moving My Money Away From Prosper
• Prosper Increases Maximum Interest Rates
• What is Prosper and How Does it Work?
• Lending Money on Prosper: My Results
• Peer to Peer Lending with Prosper Et Al.

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