Tips for Successful Lending on Prosper.com

Bear in mind that these loans are unsecured and illiquid, and the Prosper.com model remains unproven. The marketplace has not been around long, so it's still too early to tell what the default rates will be like over the life of a three-year loan and how these will compare to default rates in the broader lending industry. Given these caveats, I would not suggest allocating more than a small percentage of your overall portfolio to this asset class. Lenders who pour the bulk of their personal savings into Prosper.com are courting disaster.

Before you start lending, think carefully about your investment goals and tolerance for risk. Your next task is to translate this into an investment policy statement. Your investment policy is a concrete set of parameters that determines which loans you bid on and which ones you avoid. For example, will you lend to borrowers with poor credit (D, E, and HR)? What is the maximum DTI (debt-to-income) ratio that you will consider? How many current delinquencies can a borrower have?

Prosper.com reports numerous metrics for loans that can be incorporated into your investment policy. Using the advanced search feature, you can filter the total universe of loan requests down to just those matching your lending criteria. You can also save searches, which I find to be a great time saver.

Without a well-defined investment policy, the tendency for lenders is to chase the highest rates in each credit grade without considering the underlying credit worthiness of the borrower. These lenders typically have higher-than-average default rates and lower-than-average investment returns.

Just as with any other asset class, you don't want to commit too much of your portfolio to any single investment. I like to allocate my loans across different credit grades, loan sizes, geographic areas, income ranges, etc. I would suggest that you spread your investment across at least 20 loans and that you not allow any single loan to comprise more than 5% of your overall portfolio. If your loans are properly diversified, you will be in a much better position to weather the occasional setback.

Prosper.com has a Standing Order (SO) feature that permits you to deploy investment dollars automatically into loans consistent with your lending parameters. While this can be a great feature, I do not recommend it until you have been lending for several months and are comfortable with your lending strategy. Begin instead with manual loans and take advantage of the ability to bid as little as $50. (Loans are frequently syndicated across multiple lenders.)

Like eBay, Prosper.com uses a competitive bidding system. Borrowers post loan requests at a desired interest rate, and you must bid below the borrower's requested interest rate or the current bid, whichever is lower. Figuring out what rate to bid is the real trick. One of the biggest mistakes new lenders make is bidding too low. There are plenty of other loan requests to choose from, so don't worry if you lose a few auctions. The important thing is to make sure that the rate you get on a loan adequately compensates you for the investment risk.

I'm not going to lay out my bidding system for you in detail, since there is no one right way to do this. However, I will give you some clues to use as a starting point for creating your own.

Start with the three-year U.S. Treasury rate, which stands at 5.1% at the time of this writing. (You can view current Treasury rates here.) U.S. Treasury obligations are backed by the full faith and credit of the U.S. government and are considered among the safest investments available, so much so that the corresponding Treasury rate is often called the "risk-free rate" in finance theory.

In addition to the risk-free rate, we must also take into account several other factors, including:

• Prosper.com annual loan fees
• Call premium
• Illiquidity premium
• Default risk

Prosper.com charges an annual fee to service each loan. Currently, this fee ranges from 0.5% to 1% of the loan amount, depending on the borrower's credit grade. As a lender, you will want to pass this cost along to the borrower.

Loans on Prosper.com are callable, meaning that the borrower can prepay the loan without penalty. Obviously, it makes sense for the borrower to do this if interest rates fall. In that event, the lender would be forced to reinvest at a lower rate of return. To compensate, the lender may tack on a call premium when bidding for the loan.

I mentioned above that these loans are illiquid. Unlike bonds and shares of publicly-traded companies, there is at present no secondary market in which to sell loans. You should therefore consider adding an illiquidity premium to your bid to compensate for this risk.

Finally, since these loans are unsecured, the risk of borrower default should be a major part of your bidding model. The site provides tools and statistics you can use to gauge the risk premium for different credit grades.