Tuesday, May 6, 2008

How to make a killing in predatory lending.
(or how to lose your shirt lending to deadbeats)

A little more than a year ago while listening to the radio on the way home from work I heard about www.prosper.com, a website where individuals can bid on personal loans much like eBay. It was an interesting concept.

Traditionally people leave their money in banks. The banks then lend the money out to people who need for a while but who the bank feels can pay it back. In exchange for being allowed to use your money in this way the bank pays you some interest on your money. The bank charges a much higher rate on the loans it makes than on the interest it pays you, and the difference between the interest charged on loans and the interest paid on savings is the bank's profit. Of course this is an oversimplification, and banks offer many other services and have a variety of methods available to them to earn a profit. However, it always seemed like I could be making the profit instead of the bank if I could make the loans directly. Additionally, it always seemed like interest I paid on loans was higher than it needed to be just so the bank could earn a profit off me. If the people saving money could loan directly to the people borrowing money it seems like they'd both come out ahead. Higher interest paid to the lender than a bank typically pays, and lower interest rates for the borrower than the bank typically charges.

This is essentially the business model of Prosper.com.

Someone who wants a loan can apply at prosper.com. They create a listing to "Sell" their loan to potential lenders much like a seller might create a listing on eBay to sell something. In the listing they describe what the loan is for and why they should be considered as a potential borrower. Prosper.com then collects data from the borrower's credit report and makes it available to potential lenders.

Someone who has money to lend creates an account at Prosper.com and transfers some money to the account. They can then search and filter their way through the loan listings until they find a loan they are willing to partially fund. The lender takes into consideration the credit history, likelihood of the borrower making payments, and the reported income and debts of the borrower. They then indicate in an auction like "bid" to Prosper.com the portion of the loan they are willing to fund and the minimum interest rate they are willing to accept for the loan. A loan is not made unless there are enough bids to fully fund the loan.

Prosper.com keeps track of all the bid amounts and interest rates. Once a loan is fully funded, lenders bid against each other driving down the interest rate on the loan. Eventually the listing expiration date comes along and so long as the loan is fully funded, the highest qualifying interest rate determines the rate that the borrower will pay, and the rate the lenders will all earn.

All Prosper.com loans are 3 year loans, and borrowers can pay more than the minimum payment (and even pay off the entire loan) at any time. Prosper.com takes each payment and divides it proportionally among all the winning lenders.

As an example:

A borrower wants to buy his girlfriend a $3,000 engagement ring. Due to some bad marks on his credit rating he can't get a credit card or other loan for less than 19.8% He creates a listing at Prosper.com indicating the purpose of the loan, as well as stating his current income and monthly expenses. He explains that the bad marks on his credit report are from when he was unemployed 2 years ago, and that he now has had a job for over a year and has not missed any payments on anything since getting this job. Prosper.com reports he has a "C" credit rating and that while he has 15 delinquencies in the past 7 years and one lien in the past 10 years, he has nothing currently delinquent and no bankruptcies, liens, or judgements in the past 12 months.

Lenders discover this loan and initially decide that if they are going to lend any money they want a substantial return for the risk they are taking. Each potential lender decides how much money they are willing to risk loaning to this individual in $50 increments as well as the minimum interest rate they are willing to accept. After a couple of days 30 lenders have each decided to bid on the loan in amounts between $50 and $250. Adding up all the amounts bid the total is less than the $3,000 requested. If there are no further lenders over the next few days the loan will not be made. If more lenders decide to loan this borrower some money eventually the total of all the loan bids will exceed the requested $3,000. At this point the interest rate is set at the highest "minimum" bid. If there are no further bids before the expiration of the listing, using a smaller number of bidders for the sake of simplicity in my example, if there are 5 bidders

$1,000 at a minimum rate of 19%
$1,500 at a minimum rate of 22%
$250 at a minimum rate of 22.8%
$200 at a minimum rate of 23.7%
$50 at a minimum rate of 26%

Then the loan will be made for 26% and all 5 lenders will receive an APR of 26% on the money loaned. Prosper will take the amount bid from each bidder's account and combine it all together to make a single 3 year $3,000 loan to the borrower at 26%. As the borrower makes each payment to Prosper.com, the payment will be split up with 50% of the payment going to the person who loaned $1,500, 33.3% of the payment going to the person who loaned $1,000, and so on down to 1.67% of the payment going to the person who loaned $50.

Assuming instead that there are additional bidders, if the sixth bidder bids $250 at a minimum interest rate of 20%, this bid will knock the higher "minimums" ($50@26% and $200@23.7%) out of the "auction". What will remain will be:

$1,000 @ 19%
$250 @ 20%
$1,500 @ 22%
$250 @ 22.8%

Meaning that with no additional bidders before the listing expires, the borrower and lenders are now all looking at an interest rate of 22.8% Bidding will continue to drive down the interest rate until there are no longer any lenders willing to accept such a low rate for the potential risk of not having the loan paid in full. Potentially this might create a loan for $3,000 at 15% or so. This is an improvement of 3.8% for the borrower over anything they could find outside of Prosper.com and a significant improvement for the lenders over most other potential investments (assuming the lender doesn't default on the loan at some point).

To increase the likelihood of the borrower making their payments, Prosper.com updates the borrower's credit report with payments made or missed allowing the borrower to improve (or damage) their credit score. Additionally Prosper.com works with a collection agency to collect from borrowers who miss payments. Finally, Prosper.com makes automatic withdrawals from the borrower's bank account available as an option to the borrower and indicates in the loan listing if the borrower has chosen this option.

My initial thought was that the only borrowers that would turn to Prosper.com are "risky" borrowers who couldn't get a traditional loan elsewhere. After looking at the site for the past 16 months, I've come to realize that by reducing the potential profit that the banks traditionally make off of loans, Prosper.com can frequently generate loans at a better interest rate even for those with a great credit rating and debt-to-income ratio. These loans will generate many bids and drive interest rates really low as lenders consider them "safe" loans to make.

I tried participating in 5 different loans at $50 each time over the past 16 months, and as of yet none of the 5 borrowers have missed a payment and I'm earning an average of 15.43% annual return on my $250.

There certainly are risks that borrowers will fail to pay the loan in full, but as a lender I can choose, by looking at the credit report information, how much risk I'm willing to take on and what sort of return I want in exchange for that risk. If enough others are willing to take on the same risk for less return, then they are welcome to do so, and I'll move on to the next listing.

As a final note, through the end of June 2008 Prosper.com is offering a referral program. If you are referred by an existing Prosper.com borrower or lender, and you borrow money, the person who refers you gets a $50 referral bonus. If you lend money, then both you and the referrer each receive a $25 referral bonus. Qualification for the bonus requires that you create an I.D. within 30 days of the referral and that you either lend or borrow money within 90 days of the referral. If you intend to create an I.D. and lend or borrow money at Prosper.com, please consider using the link at the end of this post to create your I.D.

Prosper.com link with embedded referral for referral bonus

Business & Personal Loans. Great Rates. Prosper.