Two years investing with Prosper peer-to-peer lending

For the last few years I’ve been scaling up my investments with the Prosper peer-to-peer lending platform. Since there is essentially no community information available (the Prosper forum on reddit has been silent for 7 years, and Bogleheads was even less help), I was accumulating datapoints from scratch. Now that I’ve spent some dedicated time on the platform, I want to share how investing with Prosper really works.

My investment parameters

As I mentioned back in May, I have Prosper’s “recurring order” function (not to be confused with “Auto Invest”) set up to invest in $25 increments in “AA”- and “A”-rated notes with yields of 10% and higher. This has two valuable functions. First, when I deposit cash in the account it is automatically invested as qualifying notes are added to the platform. Second, since interest and principal payments are added to the same cash balance, it keeps repayments from sitting idle and therefore contributes to compounding discipline. Whenever deposits or repayments result in $25 or more in my cash balance, it’s invested in the next qualifying note that’s added to the platform.

The ineffability of rates of return

At this point we have to make a digression into the metaphysical. Annual percentage yield (APY) is a common and useful metric of investment returns because, when properly calculated, it offers a like-for-like comparison between investment products.

If you read that sentence again, you’ll see “when properly calculated” is doing all the work, and in point of fact, APY is really only useful in a few specific contexts, like bank accounts and long-term zero-coupon bonds, where your entire balance earns the specified interest rate and interest payments are automatically reinvested at the same underlying rate. In other contexts you may calculate a sort of pseudo-APY to compare products, but it should not be confused with your actual, real-world rate of return.

This is obvious to anyone who thinks about it for a moment, so there are lots of alternate methods of calculating return which are useful in their individual contexts. The “SEC return,” which you often see in descriptions of mutual funds, is a set of formulae the SEC has authorized to be reported based on dividend payments. Likewise “dividend yield,” usually seen in stock and ETF listings, is a mechanical calculation based on the company’s most recent dividend payments and current share price.

Somewhat more exotically, you have the question of actively-traded funds and hedge funds which hold some of their investors’ money in cash. How should the return of these funds be calculated? Based on the total amount investors have committed to the fund, or on the actual investments the fund makes? Should investors count the cash held in a hedge fund waiting to be invested against their cash allocation or their investment allocation? Should their rate of return be calculated only on invested cash, or on the total balance held with the fund?

These questions aren’t mathematically hard, they’re hard because there’s no right answer: you should use the calculation that gives you the most useful answer for the question you’re asking.

This brings us to Prosper’s return calculation.

The Prosper return calculation

Before we continue, let me quote Prosper’s description of their return calculation at length. This return appears both on the app and desktop website (emphasis mine):

“Your Return is calculated using a formula where (A) the numerator is equal to the sum of all the interest received on active Notes, plus all late fees received on active Notes, minus all servicing fees paid, minus all collection fees paid, plus all net recoveries received on charged-off or defaulted loans, plus all net debt sale proceeds received on sold loans, plus all net sale proceeds received on Notes sold on Folio, minus gross principal losses, plus any investor promotions credited to your account; and (B) the denominator is equal to the sum of the amount of active principal balance outstanding at the end of each month since account opening. The results are then multiplied by 12 to get an annualized return. This gives us the ‘Return’ for your Prosper Notes.”

Within this paragraph we get a few answers to how Prosper answers the metaphysical questions I posed above. For example, we’re told that uninvested cash does not count towards the return calculation: only your invested cash (“active principal”) does. But the part I highlighted describes a different confusion you will encounter as you scale up your Prosper investments: invested principal counts towards your return calculation before a single payment is due.

Remember, Prosper makes individual loans to borrowers, and you are investing in a slice of those repayment-dependent notes. After a loan has become funded by investors, the money is distributed to the borrower. The borrower’s repayments start at least a month after you’ve put in your order for a slice of their loan. But until the first payment is made, your slice of the note counts only towards the denominator of Prosper’s return calculation.

This means Prosper’s return calculation will always be depressed by the amount of active principal not in repayment in any given month. This is a feature when it reflects a loan with late payments or that has been sent into settlement or bankruptcy, but it is misleading when it reflects an eventually-performing loan that simply has not begun repayment yet.

Your Prosper return gets more accurate as loans age into repayment

To illustrate this effect, I completely stopped making new deposits into my Prosper account in October, so that all my existing notes would have a chance to enter repayment (or become past due). Only money reinvested from repayments of interest and principal would affect the denominator of my Prosper return, and sure enough, you can see the return wobble depending not on the performance of my loans, but on the amount of my total balance that reflects new loans. This chart shows my Prosper return over 2024:

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Those returns are recorded as:

• January: 10.58%

• February: 10.52%

• March: 10.53%

• April: 10.02%

• May: 9.05%

• June: 8.23%

• July: 10.19%

• August: 8.18%

• September: 9.19%

• October: 9.53%

• November: 9.04%

• December: 10.16%

The essential thing to understand is that this wild range, from 8.18% to 10.58%, does not reflect any underlying economic reality. It only reflects the amount of new principal invested each month, which contributes to the denominator of the return calculation, but is not reflected in the numerator until months later.

Calculate your own return based on mature notes

Fortunately, Prosper provides detailed account statements, which are usually available in the mobile app around the 5th or 6th of each month, and on the desktop website a bit later. These statements let you calculate your own rate of return depending on the metrics that matter to you. My preferred method is to base returns on the previous month’s “Principal Balance of Active Notes.” All of those notes should have entered repayment by the end of the following month, so it lets me focus exclusively on the interest earned on mature notes, disregarding uninvested cash and notes too new to have begun repayment. Here are my 2024 returns based on that metric (each month is shown as an annualized rate of return):

• January: 17.2%

• February: 12.8%

• March: 13.6%

• April: 15.5%

• May: 13.8%

• June: 12.4%

• July: 13.6%

• August: 11.3%

• September: 12.8%

• October: 12.3%

• November: 11.2%

• December: 12.8%

As you’d expect, the biggest differences between the return Prosper calculates and the return I calculate take place in the months where I’m purchasing notes most actively (July-September), and the smallest differences occur in the months I let my notes age into repayment (November and December), but my Prosper return will always be below my own calculation because Prosper will only show your return based on the entire lifetime of your account, and I have had my account for many, many years.

The significance of the early years, when I liquidated my notes on their resale platform at a loss (I was broke and needed the money), will be diluted over time but will never disappear from my Prosper return calculation unless and until they update their formula.

A note on “tax efficiency”

I am now required by the conventions of financial journalism to say something about tax efficiency, the idea that you shouldn’t care about the actual returns you earn from your investments, but rather how much of those returns go to your local, state, and federal governments.

I consider this a deeply unhealthy attitude that causes people to do preposterous things with their money, but the wisdom of our ancestors is in the simile; and my unhallowed hands shall not disturb it, or the country’s done for.

Interest payments on notes held in Prosper’s standard taxable account are taxed at your marginal income tax rate. Return of principal (78% of my December payments, for example) is untaxed, and losses of principal (bankruptcies, settlements, and charge-offs) are deducted from your interest payments to arrive at your total taxable interest amount.

One approach to tax efficiency might be a tax-exempt municipal bond mutual fund. Glancing at Vanguard’s list of state-based tax-exempt mutual funds, current SEC yields range from 3.14% for California (VTEC) and 3.83% for Pennsylvania (VPALX). Those yields are much lower than my returns to date on Prosper, but you can imagine someone investing on Prosper with a 50% marginal tax rate and 50% default rate ending up more or less breaking even between the two. My marginal tax rate is much less than 50% and my default rate is much less than 50% so I do not consider this to be a realistic concern. A high-income person investing in the riskiest loans is free to reach their own conclusions.

An approach I have more sympathy for is making Prosper loans in an Individual Retirement Account, which Prosper is set up to faciliate. Only cash can be contributed to IRA’s, so you can’t move your existing notes into an IRA, but you can contribute up to your annual limit and I assume you can move cash in from existing IRA’s, although I’ve never tried.

Traditional IRA’s allow you to deduct your contribution from your taxable income each year, but much more importantly allow your investments to compound tax-free inside the account. I do not know of a single person in history who has literally sold off their investments to pay their tax bill, but if you’re that person, then having your Prosper investments compound tax-free will save you the trouble of finding investments to liquidate to pay the taxes on your interest.

Another reason to consider this is that most investments people hold in their tax-advantaged retirement accounts are already quite tax-advantaged. Vanguard’s LifeStrategy Growth Fund (VASGX) only issued 2.3915 cents per share (0.054% of Net Asset Value) in short-term capital gains in 2024; the rest was taxable at the heavily-discounted long-term capital gains rate. Holding those long-term assets in a tax-advantaged account is a waste of the internal tax-free rate of return, which is best spent on highly tax-inefficient investments like Prosper loans.

The flip side is the difficulty of liquidating Prosper loans, inside or outside of tax-advantaged accounts. Once you have reached your risk tolerance for such loans, then you’d naturally want to turn off the reinvestment features and start moving the resulting interest payments into other investment vehicles. But tax-advantaged accounts, unlike taxable accounts, make this process onerous and increase the drag on returns of your uninvested cash.

To summarize, an IRA is the ideal place to hold Prosper loans because of their inherent tax inefficiency and the benefit of internal tax-free compounding, but actually doing so requires a level of sophistication and diligence that the overwhelming majority of people should not be expected to demonstrate.

Conclusion

I have much more to say about Prosper, which I surely will at a later date, but that seems like enough to chew on for now.

As I mentioned in my earlier post, the three most important risks to consider when investing with Prosper are platform risk (Prosper declares bankruptcy and your notes become unsecured claims against Prosper, not the individual borrowers), underwriting risk (Prosper got something fundamentally wrong when underwriting notes and they are in fact much riskier than they are purported to be), and macroeconomic risk (the notes are underwritten properly but an economic crisis drives even well-qualified borrowers into default).

Those risks are real. If they were not real Prosper would not offer returns 3-5 times higher than the risk-free rate on US Treasuries. But Prosper does offer such returns, and if you’re willing to bear those risks, you’re able to earn outsized (pre-tax) returns, until one or more of those risks comes to fruition.

If that happens soon, you’ll lose some or all of your principal. If that happens a long time from now, or never, you’ll make a killing. And that, to me, is the essence of investing.