This is part 2 of a 3-part review of Prosper.com. Part 1 can be found here.

The Downside

Prosper loans have more inherent risk compared to other kinds of interest-bearing instruments. The only money that should ever be put to work in Prosper are those funds that are purely discretionary; that is, money you can afford to be without.

A prudent mindset to approaching loans on Prosper is to take even greater care in evaluating them than you would with a stock on the stock market. Here’s why:

• The borrower is a complete stranger. No independent public accounting firm is vouching for the veracity of the borrower’s claims. You do get some data from Experian, but this doesn’t help verify why the borrower says they need the loan or the integrity of his/her personal character. In addition to being a stranger, the borrower is also anonymous. Prosper does not provide the borrower’s identity to the lender.
• You cannot contact the borrower directly. If the borrower is late with a payment, you won’t be able to contact them for a polite reminder. Prosper does not provide a means (outside of the bidding Q&A) to contact the borrower.
• Unsecured loans. Unlike loans a bank would make, loans through Prosper are not secured by a car title or property lien. Your only leverage with the borrower is the threat of damaging their credit report and the harassment of a collection agency should they default.
• Loss of principal. In the stock market, when a stock’s price drops, you’ve lost just some of your principal. When a loan defaults, you can lose your entire principal amount, not just part of it. You can see Prosper’s historic default rates by credit grade here.
• Illiquidity. Unlike a well-traded stock, if you change your mind and want out of a loan, you’re out of luck. You’ve committed your funds for up to 36 months. Naturally, you’ll get parts of your money back in monthly installments of principal and interest, but if you have an emergency where you need all your principal back, you’re stuck. The good news here is that Prosper is presently developing a secondary market to buy and sell loan positions. So hopefully sometime later this year, this drawback will become a moot point.

You can reduce (but not eliminate) these risks being very selective with the type of borrower you’ll lend to. You will further reduce your risk if you diversify across at least 20 loans. That way, you can have a couple loans default and still be ok with your principal.

The Upside

Despite the above drawbacks, you can still make a superior return if you’re sufficiently diversified. For example, according to Prosper’s statistical loan data (as of Dec 19, 2007), the average annual return is 8.48% on AA loans with zero delinquencies, 3 or less credit inquiries and a DTI of 40% or less. This type of return dwarfs anything you can find in a Certificate of Deposit.

The average returns for the other credit grades (given the same criteria) were 7.43% for A, 5.66% for B, 7.60% for C, 8.97% for D, 6.85% for E and -1.51% for HR. As you would suspect, the data supports common sense: borrowers with a high-risk grade should be avoided.

The third and final part of this review concludes here with a bottom-line and next steps.

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