How To Manage Your Risk When Investing With A P2P Lender

by Silicon Valley Blogger on 2008-02-218

I had the honor to write an article for the blog entitled: “6 Ways To Manage The Risk Of Peer To Peer Lending”, which discusses a few pointers about risk management in the realm of social lending. I thought I’d cover this ground a bit over here as well, with some additional specifics that reference different lending sites.

Tips For Managing Your Risk As A Lender

#1 Get in touch with the borrower (if you can).

Find out as much as you can about them. Drop them a line if you have too! At Prosper, you can ask a borrower your gnawing questions and the Q & A transcript is entirely viewable. Borrowers’ profiles provide a wealth of information that can help you determine whom you’d be comfortable working with. Prosper’s FAQ mentions that they reveal as much pertinent and relevant information as they can about the borrower so that you may be able to make informed investment decisions. Some of the data they provide lenders? Information that reveals a borrower’s credit worthiness (also known as “credit grade”), their debt to income ratio (which measures their debt load) and a borrower’s expected default rate (as reflected by a credit grade). The proprietary credit grade is culled from the borrower’s credit history with Experian.

manage risk

#2 P2P lending features are a big help.

Perform your due diligence while using the great functionality and features available to you through the P2P lending sites such as Prosper, Lending Club, Kiva and (which is now pretty much defunct). You can certainly browse around for loans you’d like to fund, but more likely, you’ll prefer to use the special technologies and tools developed by these sites. For instance, Lending Club uses a special algorithm called LendingMatch to match you up with prospective borrowers, while Prosper uses Portfolio Plans, a tool that creates a diversified loan portfolio for you without fuss.

#3 Lend to many and diversify your portfolio.

Like any other investment, diversification is KEY. At the minimum, you should consider having 30 loans as part of your lending portfolio. Or let Prosper do it for you via its Portfolio Plans feature.

#4 There’s accountability via peer pressure.

One great thing about online communities is that they harbor some level of peer pressure. Borrowing clubs, groups, cliques have a way of ensuring their members are accountable for their actions so that you may be assured that people have some level of accountability in these communities.

#5 Start lending with small amounts.

Take it slow — as a lender, begin lending with a small amount to gain knowledge and build experience. The minimum lending amount is $50 for Prosper and $25 for Lending Club.

#6 Look into how interest rates are set.

Mitigate the risk of defaults by charging a high enough loan interest rate to neutralize any potential losses you may get. But then again, the way interest rates are set differs among the P2P lending sites. Here’s an interesting comparison and analysis of how this is done: Prosper uses an auction style approach akin to how eBay does it, except that instead of bidding up prices, the format allows lenders to bid on loans. As more lenders bid on loans submitted by borrowers, interest rates are adjusted downwards. In Prosper’s case, you can see that the lending marketplace itself is responsible for setting rates. In the case of Lending Club, the company itself sets the interest rates for borrowers and lenders based on credit grades. We discuss this further in our article about Lending Club’s personal loan interest rates, where we talk about how Lending Club’s rates are being affected by our current financial environment.

Who Are Some Peer To Peer Lenders?

As expected, my first concern about trying out P2P lending as an investment approach is dealing with the amount of risk inherent in this activity. But I like the idea that you can create a diversified lending portfolio with only a few hundred dollars. And the more I read about it, I began to understand how viable this avenue is as a way to help out others and earn something at the same time.

Become a lender or investor. Estimated average annual returns are 10.4%. Open a Prosper investor account.
Become a Lending Club lender or investor. You can earn an average annual net return of 9.6%. Open a Lending Club investor account.

For more on what peer to peer lending can do for you, check out our reviews:

Copyright © 2008 The Digerati Life. All Rights Reserved.

{ 8 comments… read them below or add one }

J.D. Fournier February 22, 2008 at 6:35 am

The problem with Prosper, and probably other sites, is I can’t really trust the ratings and there is a very high default rate. Virtually everyone has experienced at least one default who has loaned any sizable amount of money. Then the ones who are in really good shape, end up paying off their loan early. So you don’t make much interest off of the good loans, and you are stuck with a number of risky loans that may default. Just one or two defaults can seriously eat into your profits for the year. Last year I had about $2900 invested and ended up with net profits of $19. And plenty of A rated loans default as well. Finally, perhaps the biggest problem is there is no liquidity. I don’t like having my money tied up for 3 years. I would consider investing on a continuous basis if I was able to pull it out when I needed.

Silicon Valley Blogger February 22, 2008 at 9:34 am

I appreciate the feedback! This type of ‘investment’ is more like dealing with bonds or CDs, but I’d be interested to know the risk vs returns ratio for this sort of thing. With bonds and CDs, you know what you’re going to earn and what interest rate you’ll be getting. With lending, it seems like it’s harder to get a good feel of what you’d be earning. $19 profit from $2,900 is clearly not an enticing return and I wonder who out there has better success stories on the lending front. I don’t expect to be making gangbuster returns with loans but I don’t expect to be making .66% on them either!

MossySF February 22, 2008 at 9:51 am

I do have a problem with the “Get to know your borrower” part of your post. Say a prospective Prosper borrower doesn’t cover his/her tracks very well (e.g., uses the same name of MySpace or Facebook plus a bit of Google snooping on public database) and you can find an array of details about the real circumstances. Now if the real story doesn’t match with the story posted by the borrower, great — you now can avoid bidding on a loan likely to default or be fraud. But if you tried to share this info with other fellow lenders (i.e., the P2P model says lenders pool resources together not just to fund loans but also to vet loans), Prosper will shut you down because it’s a violation of their privacy protection rules.

Now I’m sure legally Prosper has to do that. Prosper may not have leaked the info but it was posted on their forums. So there lies the quandry. In the current P2P model under our banking laws, the borrowers have a bigger advantage. The supposed interface between the two parties must favor the borrowers because it’s new/more borrowers that come into the system that bring in revenue.

RacerX February 22, 2008 at 10:39 am

JD – Tanks for sharing your real-world data. This area interests me, probably with a “Mad Money” Investment, but you brought up all the concerns I have. It seems like you would need a good mix of A,B and C’s target a decent return.

What was your mix? Anyone else?


Silicon Valley Blogger February 22, 2008 at 11:12 am

Like many of you, I am also getting my feet wet in this area. My plan has been to try out small amounts using an automatic portfolio set up like what Prosper already has. Needless to say, I’m going with “Conservative” for now. I believe Dough Roller has done something similar and has a lending portfolio of $250 last I read. I believe a lot of this boils down to acquiring a better feel and experience, which we won’t build unless we try. At the same time, it may turn out that this is just not the right fit for someone. It may turn out that it is not worth the time or effort to deal with as there are other more viable investment opportunities out there.

This is such a new area of transacting that we don’t yet know how it will pan out. I am of the mind to find out how others have done in this regard. One such expert is Lazy Man and of course, the Prosper blog’s own editor, Kevin of Rate Ladder. But it would certainly be wonderful if we can get more positive success stories to see what the earning potential for this really is. Obviously, there’s just no historical long term information on this.

So if you’re a newbie, start small — $2,900 seems to be a big chunk of change to try out on a fairly new market. The down side is that with very little money at stake, it may not be exciting enough, especially with returns that just don’t jump out at you. Therein lies the challenge.

Funny about Money February 23, 2008 at 6:16 pm

How does this work with your taxes? Are you reporting the proceeds as regular income? Some of the amount of each payment to you would be a reimbursement, right? And some would be interest. Do you get a statement from Prosper that breaks these amounts out? Does Prosper send you a 549 or some similar paperwork for your taxes?

And if somebody defaults, do you take the amount owing off your taxes as a loss? Let’s say you lend her $500 and she skips out after paying you $50 in principal and $10 in interest: do you declare a $450 loss? Can you take that off your taxes dollar for dollar?

MossySF February 24, 2008 at 1:11 am

Loan interest works like regular bank account interest.

Defaults are capital losses. Could be short term or long term depending on when the loan originated and when the loan was sold off.

J.D. Fournier February 25, 2008 at 7:31 am

I had a pretty diversified portfolio. Here are a couple things I learned.

1) don’t setup any automated investing through prosper, you can use filters, but in the end you need to do a little investigating before pulling the trigger,
2) Don’t invest in any businesses: Most businesses go bankrupt and there is very little damage to the individual for their business to go bankrupt if they had it setup as an LLC.,
3) Lend to smaller loans, 0-$5,000, less chance of them falling behind. I should probably write about this on my own blog but haven’t gotten around to it.

Leave a Comment