If you were investing a generation ago, peer-to-peer lending was virtually unheard of. And it certainly wasn’t an investment strategy that financial advisers would consider pitching to clients. Loans were almost entirely funded through the traditional banking system. But eventually, the marketplace recognized an untapped pathway to directly fund loans – you, the consumer. In response to the new demand, innumerable crowd-funding lenders began to emerge in the late 2000s.
A subset of the crowd-funding institutions designed their loans in a way that folks with modest levels of wealth could use them as an investment vehicle. This created a system where loans were truly funded by thousands of average Joes. The system enabled average Joe’s to generate returns on their funds while saving borrowers from horrid interest rates charged by the banks.
I’ve previously written about Lending Club as an investment vehicle. If you’re considering dabbling in the peer-to-peer space, I encourage you check out that article. But for now, let’s take a look at Prosper from an investor’s perspective to see if it’s right for you.
What is Prosper?
Formed in 2006, Prosper became the first peer-to-peer lending company in the United States. Their customers seek refuge from ever-rising credit card interest rates to obtain Prosper’s unsecured loans. Some of their loan categories include debt consolidation, home renovation, medical, and automobile. Depending on the applicant’s credit score, typical loans carry 3- 5 year terms with interest rates ranging from 6% to 36%. Loans are capped at $35,000.
As in most cases, acting as the guinea pig of a fledgling financial industry comes with its challenges. Prosper faced harsh scrutiny from investors during the early years of their existence. Criticisms focused on their excessive risk model, lack of investor options, and limited diversification. Fast forward well over a decade and Prosper has matured into a well-respected company with a refined business model.
How Prosper Works for Borrowers
Borrowing with Prosper is not unlike the traditional lending process through a bank. Prosper analyzes the borrower according to their underwriting process and assigns a risk rating. The risk rating corresponds with a tier of interest rates. Prosper’s risk model features a proprietary underwriting hierarchy that goes as follows:
- AA: Highest level of creditworthiness
- A: Second tier satisfactory borrower, may have less extensive credit history
- B/C/D/E: Below-average borrower rating, varying forms of delinquencies or lack of history
- HR: These are high-risk borrowers who can expect the highest interest rates
While borrowers might be interested in their Prosper rating, the profiling is primarily intended to categorize borrowers for investors. Each tier is associated with an estimated loss rate affecting the return for investors.
Prosper loans are unsecured notes and therefore not backed by any type of collateral. In an effort to protect investors, subprime applicants can no longer qualify for a Prosper loan. This change was part of a multi-faceted approach to improve investor returns. FICO scores under 640 need not apply.
Prosper for Investors
As an investor, you can contemplate a lineup of Prosper loans varying in length, purpose, return, and risk. New loan listings are added at 9 AM and 3 PM PT Monday through Friday and at 12 PM PT on the weekend. As soon as a loan is posted, you can fund (i.e., invest) up to 10% of the loan’s value in the first 24 hours. After that time period passes, if the loan hasn’t been fully funded you can fund up to 100% of the loan amount. This provision is meant to safeguard against investors nabbing majority stake in AA loans before others have an opportunity. When you invest in a note, the loan doesn’t become active until it’s fully funded by the Prosper community. Once it’s funded, the money is sent to the borrower less the loan origination fee. On that day, interest begins accruing.
Prosper places limitations on how much you can invest in notes based upon your net worth. You can invest up to 10% of your net worth with Prosper. In addition, Prosper accounts are free, but are assessed an annual 1% fee. This minor fee comes on top of potential losses from defaulted loans. Prosper works both in-house and through third-party agencies to maximize collection efforts. As Prosper becomes more proficient at in-house collections, third-party fees should affect investors less.
Who Can Invest with Prosper?
Prosper is open to investors in well over half the American states. While that is encouraging, Lending Club is available to investors in all but five states. Here’s a complete list of states where investors can take advantage of Prosper’s platform:
Alaska, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Louisiana, Maine, Michigan, Minnesota, Mississippi, Missouri, Montana, Nevada, New Hampshire, New York, Oregon, Rhode Island, South Carolina, South Dakota, Utah, Virginia, Washington, Wisconsin and Wyoming.
It’s also worth noting that investor requirements may vary from state to state.
Prosper’s Investing Options
Prosper allows for automated or manual investing options. During my research, I’ve found that investors tend to see only slightly better returns with manually selected notes. Granted, a hands-on approach can certainly be much more fun!
Prosper has a page called “Browse Listings.” This is like a virtual mall for investors. The layout is clean and easy to understand. This screen gives you access to all relevant data on loans seeking funding.
These loan characteristics give investors the option to truly individualize their lending strategy. I personally like the idea of spreading my money as much as possible. That means lending the minimum amount per note – $25. With Prosper’s low per-note minimum, I have more comfort in selecting D- and HR-rated notes. In my opinion, the AA rated notes lack sufficient upside to form the core of my Prosper investment strategy.
On top of leaning toward higher-risk loans, I also prefer selecting the shortest terms possible. For me, five years is far too long for an HR-rated note. In my view, shorter loan terms mean there’s less time for the borrower to encounter the type of financial hardship that leads to default. With that being said, there’s no one right approach. But I firmly believe taking advantage of the $25 per note minimum is a no-brainer.
Here are the borrower characteristics I recommend you pay the most attention to:
- Employment. If you’re like me, you’ll avoid loans where employment hasn’t been verified. I’d also sharply scrutinize potential borrowers with short time on the job.
- Credit History. Like anything else, sample size matters. A longer credit history paints a clearer picture of the borrower’s financial reliability. With a shorter history, however, the borrower’s dependability remains more of a mystery.
- Public Records. I’d avoid potential borrowers who have defaulted on previous loans.
- Repeat Prosper Borrowers. Prosper looks fondly upon repeat borrowers for a reason – they’ve repaid before, which suggests a increased likelihood that they’ll repay again.
- Income. A borrower’s ability to repay is crucial. Start by comparing their monthly payment to their monthly income to determine whether the borrower has the income to afford their payment obligations.
Prosper’s Auto Invest tool allows users to automatically invest money according to their desired portfolio type. Set your investment criteria and a target allocation and Auto Invest will automatically place orders for qualifying notes on your behalf. You can also conveniently pause orders or adjust the allocation at any time as you refine your strategy.
Atypical Risks & Issues
There are numerous examples of unsystematic risks associated with peer-to-peer lending investments. Here are the top four, in my opinion, that I think you should consider.
- Taxation is a problem. When you make money investing with Prosper, the returns are automatically realized. Therefore, if you elect for the typical taxable account your full yield is taxed just like regular income rather than at capital gains rates. Nevertheless, many investors find that the opportunity to diversify investments outside of traditional stocks and bonds is worth the tax disadvantage.
- Tax-protected accounts not ideal. If you plan to use funds in retirement, I would recommend considering a “Target Fund” or other long term mutual funds instead of using Prosper as your investment vehicle.
- Loans are not secured. Unsecured loans rely on the borrowers’ protective nature of their credit score. The lower the score the less likely they care about protecting it. Fortunately, the average Prosper borrower has a 710 FICO score.
- Notes are not liquid. In the Prosper world, you don’t own a liquid asset like a stock. So choose your notes like you are marrying them.
Filter by Loan Ratings and Characteristics. Prosper’s loan ratings and filter tools make it easy to target the types of loans you want to fund.
- No Fixed Increments to Invest. Although there’s a minimum initial investment of $25 per note, you can invest any above this minimum.
- Doesn’t Take Much to Diversify. According to Prosper, you need only 100 notes (or $2,500) to be properly diversified.
- Invest Manually or Automatically. Prosper allows users to choose whichever investing their comfortable with.
Not Available to Everyone. Unfortunately, Prosper isn’t available in every state. In addition, there are income and net worth requirements that also keep investors out.
- Potentially Risky Investments. Prosper’s note are unsecured and aren’t liquid so it’s tough to get cash out until a note fully matures.
- Less Than Favorable Tax Treatment. Earning are taxed like ordinary income which makes investing with Prosper less tax efficient that other more traditional investment methods.
Is Investing with Prosper Right for You?
Prosper has refined their approach to helping investors fund peer-to-peer loans. Prosper’s account options, research criteria, and transaction process are all on par with their top competitor, LendingClub. While I prefer Prosper’s interface to LendingClub’s, I cannot objectively recommend one service over the other. The offerings are so similar that it ultimately comes down to personal preference.
Unlike mutual funds, your Prosper portfolio offers you a wildly exciting amount of personal choice. That can be both a blessing and a curse. The success of individual notes can be extremely difficult to predict. As a result, Prosper avoids giving definitive recommendations on building your portfolio. The peer-to-peer investment industry is a young one, with no long-term research. So be prepared to learn as you go.
You’ll also want to give serious thought to your tax strategy before diving in. In the end, you may simply decide that the less than ideal taxation is something where you must accept the good with the bad. Even with the precarious nature of these investments, I highly recommend giving peer-to-peer loans a try if it’s time to introduce a new investment class to your portfolio. It’s important to note that I make this recommendation with the assumption that you’ve already built a strong core of traditional investments first. All in all, Prosper is a fun and challenging way to introduce a new and different asset class to your portfolio.