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:

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.

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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.

I would like to provide the Prosper community with some of my thoughts on building a profitable lending portfolio. Of course, what such article is complete without mention of diversification? Certainly anyone could tell you that diversifying your portfolio by spreading the risk over multiple investments is a good idea. But how many different loans should you invest in? At least 30!

Diversification

Why 30? A well-known statistical rule of thumb states that you should try to use a sample size of at least 30 in order to improve the accuracy of any analysis performed on normally distributed data. According to the central limit theorem, “as the sample size n increases, the distribution of the sample average approaches the normal distribution with a mean µ and variance ?²/n irrespective of the shape of the original distribution.” That means that even if data is not normally distributed, as the sample size increases the distribution will approximate that of the normal distribution.

It is very likely that the average return for unsecured loans is normally distributed, so the rule of 30 should apply well to peer-to-peer lending. Even if the average return isn’t normally distributed, the central limit theorem states, that the larger the sample size is the better it will approximate the normal distribution anyway. This means that the more loans in which you invest (with equal amounts per investment), the better your chances are in achieving the average expected return. Please note that I stated “average expected return” and not average interest rate. When I say average expected return, it means average interest rate - average net defaults - average fees.

Setting Limits

That brings me to the next topic of setting limits. It is very important to consider potential costs associated with your portfolio when placing bids. You should consider the probability of defaults and fees, as costs of maintaining the portfolio. When bidding on loans with lower debt grades (i.e. higher risk loans), you will need to set higher minimum rates in order to compensate for defaults and fees. Each bid placed should take these costs into consideration, as well as the desired total return on the portfolio. The “Expected Return” calculation on the Prosper bid page is an excellent tool in helping to decide at what interest rate to place your bids. (Editor’s Note: Another great tool is the Marketplace Performance Tool.)

Of course, each individual loan will ultimately either default or be fully repaid. Therefore, on an individual basis the actual cost of a loan default is much higher than the estimated cost. If a loan defaults, the cost will essentially be the original amount lent minus any principal and interest paid up until the time of default. However, if enough individual loans are made with similar estimated costs, the figures on the bidding page should provide a good estimate of the costs on the total portfolio.

Once you have placed your bids in accordance with your desired overall portfolio performance, you need to be patient and wait for the listings to close. If you’ve bid on a good listing, there should be plenty of other bidders on the loan and it should reach 100% funding. Often after a bid has reached 100% funding and it approaches the expiration, a bidding war takes place. I believe that the activity taking place is a result of the actions of two types of bidders:

1. Those looking for a good deal (that matches their risk profile) that will close quickly.
2. Those that were outbid and rebid to ensure that they win.

Do not become the latter! If you are outbid on a listing, do not be compelled to rebid. It is not a competition where you win a prize if you win the bid. If you were outbid, it was because the marketplace was willing to take on more risk than you. Besides, at the rapid pace that Prosper is growing, there will always be plenty of new listings to bid on.

It is of the utmost importance to be very patient when investing funds. You should draw the line and never cross it. You should expect to lose a lot of bids. You should also expect to do a lot of bidding before having a winning bid on a funded loan. I’ve found that only about 10% of my bids are being funded, which is just fine with me. As soon as I lose a bid, I look for another loan to bid on with the money returned to me. I think that all too often, lenders cross the line or even worse they never drew a line to begin with.

Prosper

If you properly diversify your portfolio and properly set your limits, you should be well on your way to building a profitable lending portfolio. I would recommend that you invest at least $1,500 and spreading it over 30 $50 loans. If you invest more than $1,500, investing in more than 30 $50 loans will make your results all the more predictable. If you invest considerably more (on the order of tens of thousands or more) it may not be as easy to keep your bids as low as $50. However, if you do keep your bids down to just $50, your results will be much more predictable. It will just take much longer for the large investment to eventually reach funded loans. All it takes is a little discipline and a lot of patience.

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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.