Kiplinger’s recently published an article about Prosper entitled “Risks and Rewards of Online Lending.” The article addresses the expectations Lenders should have with regard to interest rates.

“Lend to a borrower with bad credit and you can expect a higher interest rate. A borrower with a better credit history will get you a lower rate”

Generally speaking, the lower the borrower’s credit grade, the higher the risk and the more volatility you should expect.

In order to earn a risk-adjusted return, you should account for risk when setting your bid amount. For example, credit grade D borrowers generally have higher expected losses than credit grade AA borrowers. This means you should expect a higher level of return on a D listing than on an AA listing to compensate for the higher level of risk you are taking.

A number of members were interviewed for the article, one being Alex Clemens, President of Barbary Coast Consulting.

In the case of Alex Clemens, a lender on Prosper, his average interest rate on his loans is around 13% and he estimates he is getting an annual return of around 8%.

We talked with Alex today about his estimated return and I quote:

“When the reporter and I chatted, she asked me what my expected return was. This spurred a conversation about the potential for What Happens When Borrowers Do Funny Things, and after talking for a while, I told her two things – my average interest rate on my loans was somewhere around thirteen percent, and my expectation was that after late loans and defaults were factored in and all was said and done, I was hoping to gain an annual return of about eight percent on my Prosper loans.”

I clearly confused the reporter by talking about the two different rates. But now, with the article in print, I figure that there’s a real risk that some people might (a) call me out as a self-important fraud for claiming a much higher return than is realistic, or (b) encourage me to start an investment firm and give me their life savings to achieve a thirteen percent return. And while (b) would be kind of fun in the short term, I’d kind of like to avoid both outcomes, as I have a day job.

In order to assist Prosper lenders understand how loans with certain characteristics can be expected to contribute to their portfolio return, Prosper has an estimated return tool. The estimated return tool allows lenders to see a projection of credit losses and returns based on the actual performance of the loans to date. The tool is designed to help lenders understand the risk and return characteristics of loans that are similar to listings for which they are considering placing a bid.

There are four components in the average annual return – average balance, net interest yield, net charge-offs, and servicing fees.

As Alex points out:

“Everyone’s Prosper experience is slightly different from everyone else’s. We all understand the risks and rewards of participating in this small-d democratic form of participatory, community-based lending. Some do it more for the social aspect, and some more for the financial upside.”