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Note that during the recent market downturn stemming from the Asian meltdown, not only did the international funds tank, but so did the U.S. Blue Chips, Small Caps, Energy, and even gold, a perennial stalwart in such circumstances. Diversification is harder to achieve than it once was, as the world has grown smaller and practically all investment categories have grown to be inexorably linked together. So the question is, how do I achieve similar returns in any market?
An excellent option is to become a lender. Previously, this was impossibly impractical for individuals unless you were “connected” with the right people or institutions. Well, now, it’s possible.
Prosper.com is a relatively new site that pools together lenders and borrowers and uses an EBAY-like bidding system to match up willing parties based on everything from credit risk and past history to debt/income ratio and “groups” the borrowers belong to. Upon researching this option, I was immediately skeptical. Wouldn’t this be a scam artist’s paradise? Couldn’t one just keep setting up mock accounts, borrowing thousands of dollars, then walk away?
Well, here are several intriguing answers to these questions; legitimate enough that I signed up this weekend to become a lender, with the intent of returns in the 9-11% range. Here’s how it works:
Someone needs money, perhaps to pay down some high interest rate debt, or to start up a business. Through conventional lenders, some of these folks might pay a 10% rate to start up a business or a 19% rate to pay down credit card debt. For a lender through Prosper, you could bid to lend as little as $50 (which gets pooled through multiple lenders; and incidentally, as an individual lender, you can split up say, 20 $50 loans instead of lending $1000 to one person) to the business startup with grade A credit for say, 9%. Then you could diversify that with a 15% loan rate to the recent college grad with bad credit who just landed a job and wants to pay down their debt.
The strategies and analysis can become increasingly complex. For instance, the strategy site listed below recommends using ladders. For instance, until you find out if you had the winning bid, you could make several $50 loan bids with increasing rates of say, 7, 7.5, 8, 8.5%. If the bid closes when the funds are adequately attained and the rate closes at 8%, all three of your lower bids are executed at 8%. Nice way to remove some uncertainty and perhaps walk away with a higher rate than you initially sought.
As would be expected, the default rate for the low credit holders is higher than that of the A credit folks. That’s where the automated lending spread option comes in handy. By spreading your loans across several different people, categories, and credit ranges, you can actually mimic the average return for each of those groups. The ROI for each credit class is posted on the site and was surprisingly attractive. The returns for some categories exceeded 9%, even when factoring in the actual default rate (less than 1% for A) and a .49% fee imposed by Prosper. Althought the site doesn’t send your earnings to the IRS unless you reach $600, you are still bound to report your earnings, regardless of the amount (see section below on tax reporting for wording from site). If you really do your homework, use standard lending practices, and start employing some statistical analysis, you could turn this into 12% or more. Some people are actually using Prosper as sole source of income now, earning 12% themselves. Earnings from Prosper are obviously non-correlated with the general market returns. Perhaps a slight increase in defaults would be expected if the overall market tanked, but in that case, the rates the lenders would demand would increase, thus offsetting a slightly higher default rate.
Back to the earlier question of what prevents fraud: Prosper actually does income and debt verification. Then, if a borrower defaults, the loan actually goes to a collection agency. If unsuccessful, the default is reported to the credit agencies. In that respect, it seems to be as much of a deterrent as borrowing and defaulting from a bank.
Attached are some important links, including forums and best practices for utilizing Prosper, as well as stories from major news outlets. And, don’t forget to check back in a few weeks for an unbiased report for a new entrant to the Prosper community.
Tax Reprting Info:
Your income from loan interest is taxable income. Each tax year that you earn $600 or more in interest or $600 or more in borrower fees, Prosper will send you a 1099 form summarizing your taxable interest income or taxable fees, and will report this 1099 information to the IRS. (In some cases, amounts less than $600 may be reported to state tax authorities based on individual state requirements, see below.) Group leaders also have to pay taxes on their earnings at Prosper. Learn more about group leader taxes. Regardless of whether the interest income of fees are greater than or equal to $600, you are required by law to report these amounts on your tax return.