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  • Are Prosper Loans a Scam?

    Posted on April 17th, 2011 William No comments

    An interesting trend in finance these days is the rise of peer to peer lending, in which borrowers get a loan from individual investors rather than from a bank. In theory, everybody wins: borrowers get a loan at a lower rate than the bank would offer (or get a loan that the bank wouldn't offer at all), investors make a higher rate of return than they would otherwise, and of course, the facilitator takes a cut. These sites have been around for years - I originally joined, perhaps the most prominent, over four years ago - but have been in the news lately, and have been featured in the Wall Street Journal.

    So are Prosper loans a scam, and if not, how do they work?

    At the time that I joined, Prosper loans were funded through an auction format. As a lender, you would find a loan that you were interested in funding, then bid both the maximum amount you would lend and the minimum interest rate that you would accept. Interest rates started at the buyer's maximum; once the loan was fully funded, lenders would automatically compete against each other in a sort of reverse Ebay, such that the entire loan was funded at the lowest interest rate that would still bring in sufficient funds.

    In order to get funding, borrowers generally needed to write a detailed post explaining why they needed the money and how they intended to pay it off; Prosper also did a credit check and ranked borrowers on their creditworthiness. Many people participated on the site as both borrowers and lenders, taking advantage of their good credit ratings to borrow money and then lending it out again at higher rates.

    So how well did it work? Well, I invested $1,000 into the site in 2007, in half a dozen loans. At the time, all loans were for a three year period. I reinvested the payments for my loans (which had an average interest rate of around 15%) back into the site, so pretty soon I'd lent out quite a bit more than my initial investment.

    Unfortunately, this was in 2007, and towards the end of that year, the US economy fell into a recession and people started defaulting on their loans. By the time I pulled all my money out, half of my loans had defaulted and I got back only about $750 of that original $1000.

    So are Prosper loans a scam? I'd say no; the site seems to work as promised, and I got my money back right away whenever I cashed out. I lost money, but I also knew and accepted the risks involved, and until the start of the recession I had no loans in default. If a loan isn't paid back, the company turns it over to a private collector, but the percentage successfully collected tends to be low.

    Prosper itself is still around, but with a slightly modified business model; the company was rumored to be facing bankruptcy last year, but obtained more capital and resumed lending. They now claim over a million members and nearly a quarter billion dollars in loans.

    Do I recommend the site? It's hard to say. A lot of people are here because they can't get credit elsewhere, and sometimes that's for good reason. Some people might like knowing that they're providing credit to those who otherwise wouldn't be able to get it; however, you can also get that from microlending sites such as Kiva that are strictly charitable (they return your money, assuming it's repaid - which the microloans almost always are - but without interest). Prosper, on the other hand, has a significantly higher loss ratio than traditional banks. Still, it provides a nice way to diversify, and the site claims actual returns averaging 10.4%. I wouldn't put a huge amount of money into it, but if nothing else, it can be an interesting place to stash a small part of your portfolio.

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