Peer to peer lending is quite risky

I find the fellow that writes Bad Money Advice to be quite entertaining. His latest article is written about his experience with Prosper.com, which is the foremost in peer-to-peer lending. He put $1,000 into it three years ago and managed to transform it into $1,029 – which apparently is an above-average performance on the site. At least it was better than the S&P 500, but certainly less than what a risk-free GIC would have yielded.

If you are Joe Consumer and need a loan for whatever reason, you can request a loan and have people bid rates on your loan. Prosper makes money by taking a slice of both the lender and the lendee.

Putting $1,000 into Prosper and attempting to transform it into a market-beating rate is actually money well spent even if you have your entire portfolio default – the reason being that it is a first-hand experience why banks and credit card companies charge such high rates for (relatively) unsecured consumer loans. In effect, it is an educational expense. It might not even be a bad idea to give younger people an account with a modest amount and get them to “invest” the money in an attempt to educate them why making money through banking is not as easy as it seems.

The only debt investing I do is through publicly traded companies and there is some legal protection because such companies have to file a prospectus and report quarterly – when dealing with consumers, you have no such protection other than the good faith of the person behind the internet wire. In most cases, if they have to borrow money through a place like Prosper, chances are they are in bad shape to begin with and your only proper compensation for this risk are rates that would otherwise be considered usury – around 30%.

This is why “payday loan” companies charge relatively high rates – they experience the same kind of default rates as people on Prosper. Payday loan companies are vilified for charging these high rates, but without doing so, they would go bankrupt.

I love the idea of Prosper.com – I just wouldn’t invest there unless if I knew I had some form of collection that was a little more powerful than the (expensive to implement) threat of a collection agency.