Prosper is one of the pioneers in the peer-to-peer lending industry. It provides a platform for borrowers to obtain loans directly from individual lenders without going through traditional financial institutions. For investors, Prosper offers an alternative asset class to earn attractive risk-adjusted returns. In this article, we will discuss the key factors that determine the returns on investment when investing in Prosper P2P loans.
Prosper’s credit model leads to stable returns for lenders
Prosper has developed a proprietary credit model to assign risk ratings to borrowers ranging from AA to HR. Based on these ratings, interest rates are determined for each loan listing. Historical data shows that loans with higher ratings have lower default rates and generate better returns for lenders. By diversifying across multiple loans of short 3-year terms, investors can earn steady returns in the 5-9% range after accounting for defaults.
Focus on high-quality borrowers to minimize defaults
Loans with C through HR ratings tend to have higher default rates and should generally be avoided. As an investor, focus on lending to borrowers with A through B ratings to minimize chances of default. Also, set filters based on debt-to-income ratio, number of credit inquiries, income verification etc. to weed out riskier borrowers. Defaults can drag down overall returns, so building a portfolio of quality borrowers is key.
Diversify across many loans to reduce risk
No single Prosper loan can be considered safe on its own. To reduce risk exposure, every lender should spread their investment across at least 100 loans. This ensures that even if a few loans default, the impact on overall returns will be limited. Diversification is critical to earn steady returns on Prosper by offsetting defaults in some loans with payments received from other borrowers.
Reinvest returns to leverage compounding
To maximize long term returns, it is advisable to reinvest the payments received from Prosper loans into new loans. This strategy allows investors to continuously grow their portfolio and benefit from the power of compounding. Even if each loan only yields 5-10% returns, reinvesting principal+interest over many years can result in substantial wealth creation and high returns on the original investment.
By lending on Prosper’s platform to quality borrowers, diversifying across many loans, and reinvesting returns, investors can earn stable risk-adjusted returns in the high single digits or low double digits over the long run.