Or Junk Bond Fund?

I saw on several blogs people are lending on as way of earning extra cash over money market, CDs, or savings accounts. I must admit I’m not very familiar with but I think I understand the concept. It’s often referred to as eBay for lending and borrowing. Borrowers list their loan requests. Lenders bid on them. As more people bid, instead of price for an eBay item going up, the interest rate for a Proper listing goes down. Lenders can lend a small amount ($20, $50, $100) and borrowers get their loan funded from multiple lenders. Borrowers make one payment to Prosper and Prosper distributes the payment to lenders after taking its cut. As an lender, you get a loan portfolio of many small loans to many borrowers. So there’s a level of diversification that reduces the risk of lending to a deadbeat.

Is a good avenue for investing though? I’m asking this question from a lender’s perspective because I think most people reading personal finance blogs will be lenders, not borrowers.

A sustainable marketplace must be beneficial to both buyers and sellers. eBay is a good example. Sellers have items they no longer need and sell them on eBay for a better price than what they can get elsewhere (garage sale?). Buyers want them and buy them at a lower price than what they can get elsewhere (retail and online stores). As long as the price for an item is between the alternatives for sellers and buyers, garage sale and retail respectively, everybody is happy. That’s why millions of items are sold on eBay every day. Collectively, all items on eBay must sell at prices below retail. If they don’t, people will just buy from retail stores.

What’s being sold on is the borrower’s creditworthiness and their likelihood of repaying the loan. It’s a lot harder to evaluate and attach a price on than a physical item listed on eBay. The alternatives for sellers (borrowers) are borrowing from banks or credit cards. The alternatives for buyers (lenders) are money market funds, CDs, savings accounts, and perhaps even the stock market. So the price must fall between the alternatives. Borrowers must borrow at a lower rate than what they can get from banks, credit unions, or credit cards. Lenders must lend at a higher rate than what they can earn from money market funds and savings accounts. The risk of default and the amount of effort required must also be factored in somewhere there.

Back to the question of the day. Why do lenders on want to lend to borrowers at a rate below what banks and credit card companies are willing to lend? What advantages do individuals have over financial institutions? Do we have better information on the borrowers than the banks? Are we better than the banks in assessing and managing risks? Are we better equipped for dealing with defaults? Do we have lower cost of funding? If all lenders on pooled their money and formed a lending institution, what interest rate should the loan portfolio earn? Should it be lower than what other banks earn and why? I thought about these questions and I can’t come up with any reasonable answers for “yes.” I can see why lenders want to lend at a higher rate than savings account yield because Prosper loans are more risky. But I don’t see why they want to lend below what other banks and credit cards do. If banks said a borrower’s credit is worth 19% interest rate, why do we say it deserves a lower rate at 17%? Simply because we can’t earn 17% elsewhere?

If lenders like higher credit risk, why not buy a junk bond fund? T. Rowe Price High-Yield Fund, with about 400 corporate junk bonds in it, had an average return of 9.62% per year in the last 5 years. Despite the “junk” label, those corporate bonds probably are less risky than lending to subprime borrowers on Prosper. Or how about becoming a part owner of a bank or a credit card company, i.e. buy their stock? That way you earn what the banks charge and have all the advantages the banks and credit card companies have. And you get to earn those late fees too. American Express (AXP) and Capital One (COF) come into my mind as a pure plays in this area. For diversification there are financial sector ETFs like IYF, XLF, IYG, VFH, etc. I don’t necessarily recommend these investments because I’ve invested in a total market index fund. I’m already a part owner of those lending institutions so I haven’t missed out on anything. remains a puzzle to me. I don’t have a good feeling for it because I don’t see how it’s better than the alternatives. More experienced lenders please chime in.

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  1. Adam says

    You are asking the right question, but there are many reasons why an individual will be willing to accept a lower interest rate on personal debt than an institution:

    1) Low overhead. Institutions pay for a large amount of fixed cost (buildings, equipment, legal). Individuals don’t necessarily have that overhead.

    2) Profit margin. Corporations charge the fair amount of interest plus a high amount of profitability over their cost. If you look at the profit margins of most financial institutions, most individuals would be happy with a lower return compared to their alternatives.

    3) Individual attention. Companies to scale have to come up with systems to evaluate hundreds of thousands of applications per day. As a result, they are inflexible. Individuals can read an individual pitch and give it specific consideration, thus discovering credit-worthy applicants that might be missed by the system.

    I’ve made a few loans on Prosper, and no problems to date. On average, they are paying about 8% interest, and seem to be very high quality borrowers.

    It’s worth looking at.

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