Lending Person-to-Person Helps You Beat the S&P
Anyone would be weary to lend $50 to a stranger on the street, so why should you do it over the web? That’s because the numbers at Prosper.com, the first person-to-person lending marketplace in the US, have proven to be quite lucrative.
The website came to my attention after it was mentioned by commenter Drew Smith after I wrote an article on microfinance last month. The concept is sweet and simple. People seek loan amounts between $1,000 to $25,000. They then have a period of open bidding (like on eBay) where several lenders, like you, can bid in increments until their total loan need is met. Even if you have as little as $5,000 to invest, you can spread $50 increments between one hundred people with different risk levels to protect yourself from default, or not being paid back.
Borrowers post a story explaining what the money will be going towards, along with their credit score and debt to income ratio. Stories vary from paying off a house to preparing a large Thanksgiving meal for the family. Different levels of borrower risk dictate the APR, which is chosen by you as a lender.
An independent statistic website, LendingStats, gives you the skinny on how much to expect back. At the moment the true default rate is at 2.8%. That is very low, but you also have to take delinquencies, cancellations and repurchased loans into the equation, which would settle more along the lines of 12% in the red. Remember, if you spread out your money across the board one true default isn’t going to hurt you too much. Even though that $50 bill is gone, the other 99 $50 bills you sent out are coming back with interest rates as high as a consistent 20.6%.
So now that you’ve waited three years to cash in on your investment, how much are you going to make? Lets say the $5,000 initial investment was lent at 20.6% to C-credit borrowers over 36 months. The payment for them would be $187.35 x 36 = $6,744.60. Now take out your original investment, $6744.60 - $5,000 = You are walking away with $1,744.60.
Compare that to investing that money for 3 years at the average of the S&P 500 with a net profit of $978.52. One might even argue that as a long term strategy, lending money based on credit worthiness comes with less risk and more consistent returns than the stock market. Most money managers would have to agree. They have trouble even matching the S&P.
This innovative take on banking is new, as Prosper has only been operating for two years now. Bold initiatives like this humanize finance and allow us to find a way around dealing with banks for unsubsidized loans. I think it’s brilliant and will be keeping an eye on Prosper as well as other Web 2.0 startups that intend to change the face of B&M finance.
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Drew Smith said
am November 19 2007 @ 2:22 pm
Thank you for the nod in this article. I think the subject of p2p lending becomes much more interesting when viewed against the more widely-known financial vehicles of the stock market and the thousands of mutual funds that utilize the markets to create a profit for shareholders.
A lot of people feel safe with mutual funds. Especially so with index funds, I would imagine, which are attempts by the brokers (TIAA-CREF, Schwab, Vangaurd, et al) to mimic the performance (which is historically positive, at about 10% annual growth) of the Dow Jones, S&P, Nasdaq, etc.
The reality is that a mutual fund is only as safe as the diversity built into it (which is the main attraction for the educated and risk-averse investor). It is for this reason that investing in stocks is deemed “risky” and often avoided by the major investment houses (which actually invest about 75% of their cash into corporate bonds, a much safer long-term investment).
I’m not an economist, and have but the most minimal understanding of the markets as a whole and what is going on with them right now. With that cleared out of the way, I’d like to go back to my opening paragraph. The beauty of the p2p lending is, as Jerad made quite clear, one’s ability to diversify. I see the lending market as the little sister to corporate bonds. They are personal bonds of the intention of the borrower to borrow money and pay it back in full, with interest, at a later date. To me this is the essence of capitalism, with individuals producing, exchanging, and distributing wealth (as opposed to the state doing that for us).
I wouldn’t be a bit surprised to find that the lenders at the top of LendingStats’ list of most profitable go into each and every transaction/investment with a financial calculator nearby. They are aware of their required rate of return, and most importantly, the time value of money.
I chose the word “interesting” to describe the relationship between the financial markets and the atmosphere of lending. I chose this word not because p2p lending is a new idea (it isn’t), but because it appears to be riskier than investing in a large company. It isn’t.
Most stock brokers won’t handle transactions this small (most do only blocks of 100 shares or more). Furthermore, there are fees required to buy and sell stocks. Mutual funds often have minimum investments and management fees.
It’s prudent for young people to understand and invest in their company matched 401k’s and their traditional IRA’s. I feel that the relative security of the lending market places it at a nice medium on the hierarchy of risk between big time investing and money markets (investment vehicles with a maturity in less than a year).
Jerad Kaliher said
am November 19 2007 @ 11:37 pm
@Drew Smith, if you can historically hit the average of any of the major indexes you are home free. Just like you said, the problem begins when those index funds begin to suck you dry with fee after fee. It may seem like a great proposition at the average 10%, but after a thoughtful crunch of the numbers many times you come out with significantly less. That all fluctuates with the amount of money invested, of course, but my measily $5k is going to get virtually pillaged by the end of the year.
I’m not sure I would recommend any investment method as an end-all be-all. Most people would agree that diversification is a sound strategy to foster wealth. Personally I’ve always associated hyper growth with well placed risks. I like the idea of putting all my eggs in one basket after very careful consideration. I guess thats just the entreprenuer in me.
But the next time I do I’ll be sure to keep one or two out of the dozen for p2p lending. Mostly because you are completely right, p2p lending isn’t a new idea and it is the opposite of what is perceived as high risk. That shows clearly enough in the numbers.
It’s also interesting that you bring up the fundamental principal of how fund managers and brokers make money. Via transaction and fees, NOT by building wealth. Most people tend to not even approach their money managers with a contract stipulation that dictates they need to make them money. For me, that is simply madness.
Andy Bailey said
am November 20 2007 @ 11:24 am
lol, the captcha word for this comment is ‘trust’
at first it sounds risky but like Drew says, you have to pay fees for stock selling and buying, this allows you to spread your money over many smaller transactions.
good site, thanks!
Jerad Kaliher said
am November 20 2007 @ 11:38 pm
@Andy Bailey, you’re right. Vehicles like this make me feel like I have power again with my decisions. I can hedge against credit grades and judge for myself. Is that a perceived value or a real one? I’d argue a little of both, but at least it takes my money out of the markets and into the most lucrative concept in human history - lending.
Walt Chamberlain said
am November 21 2007 @ 12:14 am
I’ve investigated propser.com as a borrower. While the concept is innovative and the numbers look good, there are negatives. Prosper seems to be a clone of a system in the United Kingdom. In the U.K. it ran foul with accusations of bad business practices. A quick google of “prosper scam” resulted in quite a few complaints. These were along the lines of what we are seeing in the paycheck loan business. Repayment strong arming, harassing phones and such.
As in any business decision:
“Investigate before you invest.”
Jerad Kaliher said
am November 24 2007 @ 3:18 pm
@Walt Chamberlain, that’s very interesting. I guess I was so caught up on the investor side that I didn’t do too much research into the borrower end.
It seems that if you pay your bills on time and don’t push them into the red most people don’t have a problem.
I used to work in the finance industry and I noticed similar complaints from people who were either denied financing or put themselves in a strange position.
Neece said
am November 24 2007 @ 10:20 pm
I’ve never heard of p2p lending before so this is quite interesting. It sounds like if you diversify, which you need to do in any form of investing, it could really be profitable.
Jerad Kaliher said
am November 25 2007 @ 3:10 am
@Neece, not only diversify within the loans themselves, but it gives you another route to diversify your entire portfolio.
Mike said
am November 28 2007 @ 9:01 am
That 20% looks good up until some loans go bad. Lenders have to be careful to plan for some defaults because nothing is full-proof.
Jerad Kaliher said
am November 28 2007 @ 10:09 am
@Mike, I agree, the default rate does put a damper on really high percentage gains. Even with all the fees and defaults factored in, the return is still competitive and quite high compared to the market norms.
Luciano's Safe Car said
am March 8 2008 @ 11:55 am
What would prevent the borrower from defaulting right away? Who goes after the borrower? Certainly not the 100 lenders.