Prosper’s Problems: Why Peer-2-Peer (P2P) Lending Might Not Be All It’s Cracked Up To Be

If you read any personal finance, investing or money related blogs I am sure you have heard about Prosper Loans. In fact, I am guessing you have probably read about them more than you care to. In the unlikely, event that you have no idea what I am talking about let me briefly explain.

However, before I do I should note that I have never actually used Prosper or any other Peer-2-Peer lending service as either a borrower or a lender for reasons that will become apartment below. The following is my opinion only and you can take it or leave it as you wish. Ok, so what am I talking about?

Prosper and other similar companies like Lending Club, have pioneered a unique lending system, usually called Peer-2-Peer or P2P lending. Instead of borrowing money from a bank you can borrow money from individual lenders or more commonly a group of lenders. Think of it as Napster except for loans (although you are supposed to actually pay your loan back)

Conversely, if you have extra money you can lend it out to people who want to borrow it. Now this is where my problems with the whole peer-2-peer loan concept begins. If you go to the prosper site it claims you can borrow money from as little as 7.68% but you can earn returns of 9.49% by lending out money.

Now, it doesn’t take a genius to realize that these rates are pretty far apart. The only way to get the low 7.68% interest rate is if you have very good credit, something which most people on Prosper probably don’t have. Just think about it, if you have an excellent credit rating you have no real need of Prosper’s services, since you can get credit elsewhere.

Thus, we can expect that the average borrower using Prosper and other similar services to have worse than average credit. In all fairness to Prosper, they do do background checks on people and then they segment them into different risk categories. Moreover, Prosper never makes any claims that all borrowers are good credit risks.

In fact, Prosper recommends that you divide your loans into small segments so that if any one borrower defaults you don’t lose all your money. This seems like a sensible form of risk management, except for one major flaw. What if all or even most of your loans go into default?

The main reason I have stayed away from P2P lending is that it reminds me too much of the sub-prime crisis. Basically, you are making the assumption that by segmenting loans you have mitigated your risk. However, this is only true if you can be sure that most borrowers won’t default on their loans.

Yet, there is some evidence that default’s are significant problem with P2P loans. The best resource for this prospers.org. I especially recommend reading Fred93′s Blog on the subject of P2P defaults. It provides some pretty shocking information  about the default and other problems associated with these types of loans. For example, according to data found here up to 30% of all loans may end up in default.

Moreover, some evidence can be found on Prosper’s own site. When I first started looking into P2P lending Prosper was advertising returns of over 12% per year, but now they are advertising returns of only 9.49%. Now, this could be due to a variety of reasons, but I suspect that defaults are a large part of this decrease.

Finally, another concern with the whole P2P concept has been the financial bloggers who have been hyping it up without going into greater detail about the risks involved. The main reason they are doing this is because they get a $25 bounty every time someone signs up for an account.

For some bloggers this is a nice little source of extra income. I even suspect that some of the more popular financial bloggers earn more money by signing people up rather than through the loans they originate. Seems to me that this is a little hypocritical, to say the least.

So should you try P2P lending? Well, I have given you some specific reasons why I am not going to be jumping on the band wagon anytime soon. However, I would love to hear from people who have had a positive experience with Prosper. Please leave your comment below.

This entry was posted on Saturday, May 10th, 2008 at 1:45 pm and is filed under Loans, P2P Loans. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.