I had an interesting conversation with a friend, who's very conservative and uncomfortable with prosper's model.
I tried to interest him with my high average interest rate of almost 14%. He's earning 13% on a synthetic bond product linked to the price of a tech company's stock - it trades as a close end fund and pays a 13% dividend. If the price of the underlying stock drops by more than 30% from the point of contract initiation all he gets is the principal value at the time of maturity - he gets an equity, but a smaller amount. So far his investment is in the black and it looks like he'll get his 13% interest.
It's an interesting idea, but certainly has risk depending upon the fortunes of the underlying tech stock. At least it's liquid.
We discussed what's the most we really could expect prosper to do for someone. Somehow, I couldn't imagine putting more than $80k into prosper. At least at my financial level. Even then I wouldn't want to drain my cash supplies by that much. It's conceivable I could borrow it and arbitrage the interest rate spreads. If I were to do so, I think the maximum interest I could obtain would be an 8% spread.
Here's the model:
$80k in loans of $400 each would be 200 loans. I would have to reinvest 1/36 of that amount after making the initial investment over 2-4 months. 1/36 of the loans would be returned to me each month, which would require me to make 5.6 new loans each month. About $533 in interest would require about 1.6 additional loans to be made. Not bad, less than 2 a week. The problem is that I'd be taking on quite a bit of risk to earn 8% on $80k, which is only $6,400. After taxes it would be $4,000 in interest. That's a net of $333.00 per month or a gross of $533.00, not bad, but not enough to live on. Is it enough to justify taking on $70,000 in debt (assume I'd put $10,000 of my own cash in)?
Would I be able to take out a mortgage with $70,000 in outstanding installment debt applied against my income - I assume it would go against my income, not my assets.
One experiment is to look at it over a longer period of time. After 20 years I would be NETing $1,250 per month (after taxes) with $92,000 in NET principal. In your opinion is it worth the risk and time?
Regards,
makingourway
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4 comments:
On the question of whether it is worth the time, I guess that the answer would depend on how much time you have - not only time to bid on the loans but also to keep the paperwork you would need for tax returns etc.
On the question of whether it is worth it financially, do your expected returns factor in the possibilty of default? With 200 loans outstanding at any one time, I would expect the probability of one or more defaults occuring to be quite high (even if you limit yourself to better rated borrowers). Is 14% less defaults sufficiently higher than your cost of funding to justify the risk (and the time). My instinct says "yes" but Prosper is so new that I would not know how confident I should be in making this assesment.
trainee,
Great comments!! Thanks so much for the thoughts.
I expect I'll only need to place 1-2 loans per week at $400 per loan. That means about 20-40 minutes each week.
I believe 200 loans should be enough to sufficiently diversify the portfolio with the full realization of the expected rate of default (blending various credit ratings).
I expect to keep most of my investments in B grade or above, however, I'll be aiming for a net marginal interest rate which should prevail if I have to move to lower credit loans (after defaults).
What worries me most, is the question of opportunity cost. Say I invest $10k and borrow $70k at fairly reasonable interest rates, enough to make the 8% iterest rate margin.
Is it worth doing?
Or will other investments become more worthwhile.
in my model, I take the interest rate gains after tax and compound them back into my wholely owned capital where I plan for a 12.5% rate of return after defaults (vs. the 8% margin for borrowed monies).
After 20 years the $10k principal grows to $160k principal due to compounding.
Are there better ways to invest and earn money?
I have a lot more money than $10k or even $80k, my core investment (equities) and retirement portfolio is about $360k.
Am I wasting my time with prosper with such small amounts or is it part of the multiple streams of income argument?
Thanks for your thoughts,
have a great weekend,
makingourway
I guess the problem for me is whether it's realistic to believe that you can really make 8% over that many loans--does Prosper really have enough quality borrowers to make it possible for you to fund that many loans and retain a decent overall quality in your portfolio? Or are you going to have to lower your standards on who you are willing to fund, thus increasing the risk?
$10,000 growing into $160,000 over 20 years is close to a 15% rate of return - compounded.
If I could get 15% pa on all my investments for 20 years, I would be a very very happy man indeed. This is better than the long run return on US stocks.
Question to consider: the last decade or so has been a generally good time for the economy with interest rates at historically low levels (at least in nominal terms). Credit defaults have not been that bad outside the tech/telecoms sector. What happens if the Fed keeps raising rates and the economy stalls? I'd expect the default rate to rise. It's also possible that the spreads may rise as well in that scenario. This isn't to say that I think your plan isn't a bad one - actually I think it's pretty good - but the possibilty of returns varying from your model is quite high.
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