Social Lending Risks & Rewards

loans Social Lending Risks & Rewards Social lending start-ups like UK based Zopa.com and the US based Prosper.com bring lenders and borrowers directly together to cut out the banker and help both parties save money. This business model is similar to eBay in that a listing is created and bids are taken from competing buyers. This enables the loan rate to get bid down giving the borrower a better rate while still giving the lender a good return on their investment. The loans are unsecured and amortized over three years with no penalties for early repayment.

Zopa, which stands for Zone of Possible Agreement, launched in 2005 and was the very first social lending site of its kind. Prosper quickly followed Zopa’s lead by launching in the US on February 13 of 2006. Since its debut Prosper has seen its membership grow to 140,000 and it has helped fund over $27 million in loans. Borrowers are assigned a letter grade of AA to E, HR (high risk), or NC (no credit history) according to their credit score and can borrow as little as $1000 or as much as $25,000.

While the lenders cannot gain access the borrower’s credit report or real name, they are able to view their credit history. That is, they are given information on the number of delinquencies, public records, date of first recorded line of credit, total credit lines, and the number of credit inquires. The lender’s investment return on any loan is governed by the level of risk they are willing to take (via the borrower’s credit grade) and by state-specific maximum allowed interest rates that can be offered to the borrower, which range from 6% to 30%.

For their services, Prosper charges a 1% closing fee and a 0.5% servicing fee that accrues daily over 3 years. The rest goes to the lender with interest that’s compounded daily. So for a $5000 loan funded at 10% for three years, $50 (1% of principle) plus $40.40 (0.5% of daily principle balance over 3 years) will go to Prosper and the lender will get $5,767.68.

While 10% initially seems like a great return for the lender, because the loan is amortized over 3 years, it actually only works out to be an annual interest rate of about half of the reported 10%. In order to get the true 10% the lender must immediately reinvest the monthly payments that he/she receives from the borrower. If the lender does not, the $767.68 over 3 years amounts to an average annual rate of 4.78%, which is less than ING’s one year CD rate of 5.10% or HSBC’s online savings account that earns 5.05%. Plus, unlike lending to an actual person, CDs and savings accounts are a sure thing and there are no risks of default.

Prosper boasts a default rate of merely 0.5% but it’s essential that you as the lender choose wisely when it comes to lending your money to strangers. I would suggest minimizing your risk by funding several loans at lower amounts, say $50 to $100 each, rather than putting all your eggs in one basket. Another great way to minimize your risk is to simply limit your funding of loans to people who meet a certain criteria like having a credit grade of X with Y lines of credit, Z number of delinquencies, and so forth.

I have been using Prosper for about 4 months now and I am mostly pleased with it. I have helped fund three loans so far with an average rate of 19.21% but because I am not reinvesting those monthly payments it actually works out to be an annual return of 10.76%. It’s a nice ROI but it also comes with a lot of risk. The borrower could quit paying at any time, file for bankruptcy, or die and I could lose all of my investment. So far though, none of my borrowers have been late, none have defaulted, and thankfully none have died.

What I Like:

User friendly website with intuitive design
Ability to create groups and join groups
Leader and group rewards that benefit each
Better loan rates than other banking institutions
Good investment opportunity
Good tools like the borrowing calculator
No monthly fees or hidden costs
Access to all loan data and default rates
Ability to create standing orders for lending money
Bidding war between lenders that benefits the borrower

What I Dislike:

No lending calculator that shows your exact ROI
No earned interest on money in your Prosper account that isn’t loaned out
That fact that Zopa is taking forever to launch their site in the US

UPDATE:

Since my initial post on this over a year ago, one of my loans went into default and thus I lost 50 bucks. It was my own fault really because I was funding a loan for a guy who had a D credit grade and 4 delinquencies in the last 7 years. I viewed it as rough learning experience and in response tightened up my criteria for lending on Prosper. Since then I have funded 4 additional loans ($50 each) with an average interest rate of 19.01%. Of these 4 loans, one has been totally paid off and the other 3 are all current. Once these 3 loans are completely paid I will have recovered my lost $50 from the one defaulted loan.

Prosper still does not give earned interest on any funds that sit in your account and they still have not added a lending calculator despite receiving comments about these issues from Prosper’s own customer service repss. I did notice however, that we can now at least remove funds less than $50 from our account whereas before we couldn’t.

Several other social lending sites have also been formed since my first post including Zopa’s US site, LendingClub, and GlobeFunder. For those individuals looking for family or friends to fund their loan, there’s Virgin Money. All of these are unique in their own way and I look forward to covering them in more detail in the future.

Please Tweet, Bookmark, or Share This Free Content Using These Services: