One of the major concerns that lenders/investors have in peer to peer lending as an investment, especially when they are first learning about it has to do with the lending platforms themselves. We fund the loans on the lending platforms. If we are funding the loans and the lending platforms like Lending Club and Prosper are not, then what stops them from just throwing every potentially approvable loan up to see if it sticks. Why not put everything up on the platform and let the lenders decide what they will fund? After all, if they make money funding loans with our money and collecting an originating fee and a servicing fee then why not put up as many loans as possible?
After combing through the prospectuses and the websites, I had to settle for the Bankless Times and their excellent intro piece that indicates that Prosper's approval rate is 12.5% or 1 out of 8. Right away we know that Prosper doesn't just throw new loans up on the platform to see if they will get funded since we see that 7 out of 8 get declined before we investors even get to see them.
Why does this matter?
The state of the current P2P Lending industry is such that demand for outloans is currently outstripping supply. There are a couple reasons for this including the discovery of p2p loans by the public in 2013, high profile investments made in 2013, excellent returns and the interest from institutional investors in peer to peer lending as an investment market.
What Prosper could do (and Lending Club as well) but neither of them does is just put every single loan applied for up on their platform. Many less than prime credits would still get funded both by in the know investors seeking yield and who understand the risks involved, as well as many who wouldn't know of the risks involved but saw the eye popping 30%+ yield. Some would probably just take their chances and say well if some default but some pay off it's still a much better yield for my money than anything else out there. In some cases, they'd be right.
Instead of doing that, Prosper and Lending Club protect us and protect their own reputations as catering to mostly prime borrowers. Trust in the underwriting of the platforms is important to the success of peer to peer lending since the platforms verify the information and not us investors so this is a step they take to underwrite based on prime borrower credits and build trust into the system.
Platform Underwriting Reduces Risk
Prosper has some inherent tools in its underwriting policies that limit our risk. The biggest limitation they put in is the maximum loan a borrower can apply for based on the rating of the loan. A D rated loan cannot apply for the full $35,000 limit that a AA loan can. Here is the breakdown:
|Default Risk per Prosper.com|
|Loan Rating||Cap on Loan Size|
These limitations show us that Prosper believes that limiting the amount that they lend, which translates into a limit in the monthly loan payment creates a lower risk for them, for the borrower and for us as investors. A loans can borrow the full $35,000 but an HR can only borrow $4,000. If Prosper was solely interested in collecting origination fees at the closing of a loan, then the caps would be higher or maybe there would be no loan cap at all. This is clearly not their policy as they work very hard to adhere to underwriting standards that increase the likelihood of a full payoff for all investors.
Prosper makes money 2 ways: a closing fee on the loan which is the origination fee and a monthly servicing fee to service the loan once funded. They could choose to maximize their closing fees by approving and funding most of their applicants. But they don't. They only approve 1 in 8 loan applications. They could choose to maximize their closing fees by letting any borrower borrow the full $35,000, which would mean a higher closing fee for them. But they don't. They try to underwrite and approve loans they truly believe will pay out for the entire term and as a result it helps us investors to get paid on time month after month.
We will examine more of these tools and policies going forward, and this does not lessen our own due diligence and proper loan filtering that is still required to make profitable loans but it's nice to know that Prosper is working to try to make loans that will profit themselves and us investors together.