Do you know the rule of 72? If you have an investment earning interest, if you divide 72 by that interest rate, you will know approximately how long it will take for you to double your investment. For example, if you have an investment earning 6% interest, it will take you approximately 12 years to double your investment. Does that mean that if you have a loan with a 24% APR, you’ll double your money when the loan is paid in three years? Unfortunately, the answer is no.
The investment you make by lending your money with a three year fixed-term is a declining balance. Each month as you receive a payment on a loan, a portion of the payment pays down the principal. Your investment is decreased by the principal paid. If you make a fixed-term fixed-rate loan of 24% for three years, you’ll earn about 41% of your initial investment. So how can you make the rule of 72 work for you on Prosper since you’re dealing with declining balances?
You just need to make sure you are compounding the interest. You can compound the interest by reinvesting the principal and interest you receive into new loans. In order to be able to do this consistently, you’ll need to have enough principal loaned to receive $50 or more in principal and interest with relative frequency. Here is a simple table to help you figure out how much principal it would take to generate $50 in principal and interest in a month:
|Average Interest Rate||Principal Loaned to Receive $50/mo. in P&I||# Years to Double Investment|
Note that this table does not take into account late payments, defaults, and fees. In order to use the rule of 72 for your loan portfolio, you will need to invest at higher interest rates to compensate for late payments, defaults, and fees. The table does at least provide a good point of reference for estimating the amount of principal needed to originate one new loan a month with reinvested principal & interest. This isn’t to say you should only compound monthly, but you will need to compound at least that often to apply the rule of 72. If you have more money loaned out, you will be able to originate new loans more frequently and compound your investment more frequently as well. Compounding monthly is a good start, but compounding more often is even better.
In order to calculate the principal required, I simply used the MS Excel finance function “PV” (present value). I just entered the interest rate/12, term (36), payment ($50) and then rounded up the result to the nearest $50 increment. For example, to calculate the principal required to receive $50 each month for a 6% interest rate, the Excel formula is =PV(6%/12, 36, 50) which returns -1,633.55. The result is negative because it represents an outlay of cash (the positive 50 in the equation represents a receipt of cash). You could also use the following mathematical equation:
where P = principal loaned, A = payment amount, i = periodic interest rate (be sure to divide the rate by 12), and n = the number of payment periods (in months). So far I’ve loaned out $2,100 at an average interest rate of about 19%. With that amount of principal loaned and average interest rate, I’m receiving about $75 a month in payments. If I estimate 10% late payments/defaults/fees, I should receive around $67.5 or $2.25 per day. At that rate it should take me about 22-23 days to place a new bid with the accumulated payments. If I’m able to achieve a total adjusted return of about 9%, I should be able to double my money in about 8 years.
WealthBoy is a new Prosper lender (WealthBoy) and writes the personal finance blog WealthBoy. He performs financial and statistical analysis in his day-to-day job. He enjoys following the financial markets and seeking out new ways to invest. He is well versed in investing in mutual funds, stocks, and options and has found peer-to-peer lending to be another good method for investing. He also loves to watch Florida Football and Florida Men’s Basketball.