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Surprise! Peer to Peer Lending is Risky

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Earlier this week, Mark Gimein wrote a great article on TheBigMoney.com detailing, statistically, how risky person-to-person lending really is. I’ve always known it to be peer to peer lending or social lending, but the article calls out the riskiness of Prosper.com, the first and one of the largest of the peer lending networks.

To look at the results of Prosper’s loan marketplace, though, is to see not a solution to the credit crisis, but a microcosm of it. Loans to unqualified borrowers; reliance on mathematical models that turn out to be a lot less useful than they seemed; failed hopes that high interest rates could make subprime loans profitable; sky high default rates—Prosper has it all. Prosper’s Web site advertises returns of 6 percent to 14 percent for lenders. But the reality is that the lenders who loaned $188 million through Prosper have not earned anything like these returns. On the contrary, the majority of them have lost money, as they’ve watched their loans go bad at shockingly high rates.

The takeaway from the article isn’t that you should avoid Prosper, it’s that you probably should avoid peer to peer lending entirely. (In fact, I think Prosper should be lauded for making their loan data public!) There simply wasn’t, and likely isn’t, enough information for you to adequately price in the risk of default. Are things better today than they were in 2007? Probably, but the reality is the peer to peer lending marketplace is a lot riskier than you think.

Whenever there’s something new like this, there’s a subset of its users who will find a way to benefit. For the longest time, the early adopters thought they were the ones who benefited. Unfortunately, as it turns out, the true beneficiaries were the social lending networks (who take a percentage of the loan in fees) and the borrowers themselves (who received loans they probably wouldn’t have qualified for).

When I tweeted this article out, @PotatoPeeler said – “Do we need a whole article to tell us that lending money to random people on the internet is an absolutely horrible idea?” I wholeheartedly agree!

I know people who have been lucky enough to avoid the default plague so far and it seems as though it’s only a matter of time. A little bit of me is now glad that Maryland residents aren’t permitted to “invest” in these loans.

(Photo: nitrofive)

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42 Responses to “Surprise! Peer to Peer Lending is Risky”

  1. NateUVM says:

    Any data on Lending Club? It has been my impression (I have not invested with either) that the interaction there is different from Prosper’s, that risk is managed a little better. Any comment on that?

    I suppose I would be surprised, if the points made in this article are true, if there was any difference, human nature being what it is and with them both being peer-to-peer intermediaries.

  2. Jeremy Olexa says:

    cmon now, every investment has its risks. This article packs a big dose of common-sense and I wonder why you even felt the need to write it.

    • PotatoPeeler says:

      Agreed. That was the exact point of my reply to Jim’s tweet.

      • Jim says:

        I think the value wasn’t so much in what was presented, you could find that on your own, but that no news source has written that before. A lot of people get their news only from more mainstream press, versus blogs and whatnot, and until that piece very few news places talked about peer to peer lending that way.

  3. I can’t say that avoiding it altogether is really the right tack to take either.

    • Jim says:

      I avoid investing in something that I can’t properly understand and analyze and I think social lending fits in that category. They quote certain percentages for default but reality diverges, that makes it unpredictable and, for now, something to avoid entirely (in my book).

      I don’t invest in options or futures because I don’t adequately understand them and I don’t believe I, or anyone, fully understands social lending yet. Are there opportunities for people who “figure it out?” Yes, it’s just not for me and not for most people.

  4. I’ve heard a lot about Prosper over the past year and considered getting involved myself. I will think twice now, even though you kind of point out the obvious fact that the lender is taking a decent amount of risk with p2p lending.

  5. nickel says:

    It’s interesting (and a bit curious given what’s happened at Prosper) that after 2+ years in the business, Lending Club still hasn’t had a single default on any of their Grade A loans.

    I’m still not sure what to make of this. Is Lending Club that much better at filtering out bad borrowers? Or have the defaults just not started — yet?

    • Jon says:

      They HAVE had A-rated borrower defaults. Their page currently shows .21 percent.

      I know firsthand as I took my 25 dollar signup bonus and funded one A-rated borrower. Got about 5 payments before that borrower went into “bankruptcy counseling” last November.

      I wonder if this loan is considered a default, if not, how long, (and how many others like it) are in limbo and don’t count as failed loans.

      I do get to look at the not so pretty borrower credit score graph change that went from “750-799″ to “499-”….:( All the nice tools in the world can’t change the reality that you are making unsecured loans.

  6. Kate says:

    I read about Lending Club on another financial blog I visit and thought that it was a very risky move. However, the fact there is a credit score requirement makes it a little more palatable. After reading this article, I wouldn’t go near Prosper with a stick…

  7. Chris says:

    I am curious to find out what actual lenders think of Prosper and Lending Club. Any of you out there?

  8. mapgirl says:

    When I was living in VA before Prosper went into their quiet period I had one loan default to bankruptcy filing and one loan that is constantly late but not yet defaulted. I also have one loan paid off very early and 5 that are still doing well.

    I would still do peer-to-peer lending if I could, but DC is not authorized. I think it depends on how conservative of a lender you are. I had one Grade E loan, and that was an accident. I thought it was a Grade C or higher. But that guy has paid his loan on time and is in the process of final pay off right now.

    For the most part, I think I’ve had good luck because I was a very conservative lender. I know what idiots are on the internet and I stuck to some basic criteria. 1. Must own a home. 2. Must have a credit rating of C or higher.

    My estimated ROI on Lending Stats is like 3%, but in truth, for my paltry $275 investment, I made out very well. My actual ROI is more like 16.9%.

    Would I continue to do Prosper if I could? Yes, I think so. But I wouldn’t sink too much money into it since it’s not very liquid cash.

    BTW, the URL does not go to my blog. It goes to my LendingStats.com profile where you can see info about my loans. I have to say, that kind of data access in Prosper is great. I love that kind of stuff being an accountant at heart.

  9. mapgirl says:

    Oh I should explain something about the rate of return I posted at 16.9%. That is the total I have received so far $321.46 as of today, divided by my original investment amount of $275, minus 1. Maybe I did that calculation wrong. Not sure. Even so, Prosper says my rate at acquisition was 13+% and I’m doing better than that despite my default. Must be the Grade E loan that is doing well. (19.25% Yield)

  10. Before Prosper.com went into their quiet period, I was an active lender there. I still have the loans that I lent before the quiet period. All told, my return is about 10%. I have had two defaults, but the model I was using was a mid to high risk model, so it was expected. I’ve also had one pay off early and still have several that are current or ahead and only one other that is in any trouble at all. If my state were allowed to lend there, I would still be doing it.

    An observation: LendingClub seems to have much more restrictive practices for their borrowers and lender which likely leads to their no default A’s. Prosper is a much less restrictive site, but I think the essence of it all was to allow for some people to get better rates than the traditional bankers were giving and also to allow for some who couldn’t get loans without outrageous rates to get them at middle rates(20%)

  11. tbork84 says:

    From how Prosper.com was marketed, I can understand how people could have gone in with blinders on. But everyone should understand that with any investment comes risk, and it is up to them to fully research what they are putting their money into. Nowadays though to settle for safe bets means getting absolutely zero return on your capital, so the option to be the lender would definitely appeal to some people. It pays to recall how some of the largest lenders in our economy are fairing right now and realize that even highly rated debt still carries risk.

  12. Jeremy says:

    I don’t think P2P lending is any more risky than most other types of investing. The key is simply to treat it like you would with other asset classes, and in this case, I’d classify P2P lending on the same level as investing in individual high-yield corporate bond issues.

    That’s all this really is, but the only difference is that the bond (note) ratings come from a personal credit score tied to an individual, not a Moody’s rating tied to a publicly traded corporation. If you went out and bought a dozen high-yield (junk) bonds there’s plenty of risk of default.

    I think the biggest issue is that people somehow don’t know how to measure risk and for whatever reason P2P loans seem safer even though the yields are much higher than you can get anywhere else. I don’t know if it’s the thought that because you’re investing in real people and not a faceless company your money is safer or what, but if you take the risk at face value and know what you’re taking on in return for the yield it’s a fine investment.

    But I guess that goes back to what Jim said about not investing in things you don’t completely understand. That probably means most P2P lenders really shouldn’t be investing their money this way.

    That being said, I’ve been investing with LC for a while now and have nothing but great results. I’ve invested in a bunch of notes ranging from A-E and have not had a single default or even late payment yet. In fact, one of my C class notes paid the loan off in full six months early. That made for a little over a 12% return last year.

  13. @Jim – “I avoid investing in something that I can’t properly understand and analyze and I think social lending fits in that category.”

    To some extent is this not also true for your dividend stocks. You can understand a business model, you can analyze historic performance but conditions can and do change.

    LC may have a better track record today, but like nickel said “Is Lending Club that much better at filtering out bad borrowers? Or have the defaults just not started — yet?” Could be both!

    All this being said my personal belief to date on social lending is that it can only be worth the risk if you can spread your investment over a fairly wide group of borrowers; never put all your eggs in one basket.

  14. eric says:

    I just know LC has a better reputation that Prosper. I think of it as play money. We’ll see how it goes.

  15. Jake says:

    Lending Club’s statistics including default rates are easily available. You can even download everything and parse the data yourself. Check out:
    https://www.lendingclub.com/info/statistics.action

    Granted Lending Club has had a fairly short lifetime so far, but it seems like a decent investment option to me.

  16. Izalot says:

    Lending Club peaked my interest and I’ve taken advantage of their promo code. I’m curious to see if the loans I picked will default and based on this experience may wet my beak for a very conservative amount.

  17. Soccer9040 says:

    I used to be a lender on Prosper, then they went into their quiet period and never came out with a license to lend in Ohio so I’m stuck collecting on my loans.

    From my experience, I invested approx $2,500 into prosper spread out in $50 loans to people. I have had 6 people default at some point in their loan. Some defaulted early on, others defaulted after they paid back $45 of the loan, IE im out $5 on that loan.

    Either way, I’m still ahead of the game. Thats more then my 401k and IRAs can say.

    Yes its risky, but you need to be willing to invest the time to read the loan application and ask the right questions. Just like picking stocks you need to do your homework.

    I wont completely write prosper off. It was game changing and they didnt have the historical data to back up their default rates. Given time it should all smooth out.

    I’ll still invest if they ever get their act together in Ohio

  18. cubiclegeoff says:

    As with all investments, your return is related to your risk. If you want higher returns you have to risk losing your money. I don’t think p2p lending is a bad idea, as long as you know what you’re getting into. But like all investing, there will always be people that don’t understand what they’re doing and only look at the possibility of return, and then get mad that they lost money.

  19. Tiffany Fox says:

    Prosper has an Open Letter to The Big Money requesting a retraction for the inaccurate portrayal of lenders’ returns and experience on Prosper. If you’ve read the post above, it would be wise to also read Prosper’s refute: http://bit.ly/8az3Pv

  20. Tony says:

    I invested in Prosper about $4600 in a total of 92 loans before they went into the quiet period. Two years later I’ve had 13 loans defaulted and 11 paid in full early. I used their “Moderate Risk” portfolio which had a combination of loans rated AA to D.

    According to lendinstats my actual rate of return is 2% which agrees with my own Quicken data.

    I will not continue to do peer-to-peer lending. It is a hassle to keep track of all the principal and interest payments and the rates cuoted on both Prosper and LC are not real. They don’t factor in defaults, fees, etc.

    If you want to borrow money just purchase corporate bonds from a Brokerage firm like E-Trade. You’ll get a lower interest rate but the risk is much better understood. After Propser wnt into their quiet period a purchased about 12 individual corporate bonds from different US companies and my average annual return is 9.5% with no defaults so far.

  21. Mark says:

    I started Lending Club last month. One of the benefits I like is the ability to only put $25 into one loan, that way you can diversify and mitigate risk. I am excited about Lending Club and have read all the numbers and understand the risks. I am looking forward to its ‘self fueling nature’ about a $750 investment will earn you $25 a month, to re-invest into the system. I looked into Prosper and was not impressed with the way they do buisness.

  22. Peter says:

    The article talks about prosper.com – and I can’t speak to that one since I don’t use it.

    I’ve been investing with Lending Club for a while now, and while I’ve only got about $300 invested right now – so far I’ve had a positive experience. All my loans have made their scheduled payments, and I have a zero default rate. Of course, with Lending Club you can choose only to invest in whatever loans you’d like – and borrowers have a credit check run, in addition to income verification, and other safeguards. You can even ask the borrowers questions about their situation, why they’re getting the loan/etc.

    Each lender is given a rating with the best being A going down through E (I think?). I’ve been very careful about which loans I invest in and have only invested in A or B grade loans. So far I’m making about 11.2% on my money. Better than a high yield savings account. I realize that there is some risk here, but I think you can carefully manage your risk by the types of loans that you’re investing in.

  23. I do not agree at all with peer to peer lending. Not only is it risky for the person investing, but it just doesn’t seem right to be lending money to people at sometimes extremely high rates. I would rather take a 0% rate of return on my investment in an organization like Kiva.

    • FinEngr says:

      PTLG – Agreed. I’ve been interested in micro-lending ever since I saw this special on Mohammed Yunus.

      There’s been a lot of type around these peer-peer sites. On Lending Club, I was amazed at how “well” off these people were. Listed professionals with higher than average credit scores asking for loans under $2,000 had me racking my brain. I understand if they’re looking for a lower rate, but given their stats – wouldn’t they be able to take those steps on their own?

      Sites like Kiva.org offer more social investing. Many of the individuals may not have the same banking opps as here in the US. Plus, your investment goes more towards ending poverty than backing bad decisions.

    • NateUVM says:

      I don’t have the data right at my fingertips, but I think the rates these sites are offering borrowers are still a lot lower than any kind of unsecured personal loans that you can get most anywhere else. Secured loans, maybe not, but that’s not what these P2P sites offer.

  24. NewPerspective says:

    I’ve loaned to 88 people on Prosper so far… 26 defaults. Enough said!

    • Soccer9040 says:

      WOW!!! Did you take the time to read the loan listings? What kind of people did you lend to? I’m sure if you got into the C-F categories where interest rates were in the high teens you might expect a high level of defaults like this.

  25. CK says:

    There’s a reason people go to Prosper for a loan. Banks, etc already found them to be a bad risk.

    • Jon says:

      Although I was burned by my one sample (A-rated) loan with my Lending Club sign-up bonus, I think CK’s statement is simplistic.

      If I needed a loan, why would I pay extra to get that money from a Bank (with their extra overhead). As a borrower, it’s all about the rate, and, just like with online banking, these online lending organizations probably have lower overhead which should free up lower rates for borrowers, and higher rates for lenders.

      As I’ve read elsewhere, P2P lending is a new asset class. When I see the RATE of defaults decrease, and see a correlation to other asset classes, I might find it a reasonable risk to use as one investment.


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