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Prosper vs. Lending Club SmackDown–Who has the best interest rates?
Important Update: Prosper has suspended its lender program while it registers debt with the SEC. Fortunately, LendingClub's lender and borrower programs are both active and offer attractive interest rates and terms.
If you think Prosper and Lending Club set interest rates the same way, think again. In fact, how they set interest rates is fundamentally different.
Prosper versus Lending Club
Prosper follows an Ebay auction style format, where the interest rate is set by the lenders through bidding. Lending Club sets the interest rate based on a formula, and lenders either accept that interest rate or not; there is no bidding, much like Craig's List. Whether you are a lender, borrower, or both, understanding the difference and how each site sets interest rates is critical. So in this SmackDown between the two Peer-to-Peer Lending giants, we'll look at how each sets interest rates, and then discuss how to evaluate which one is best for you.
How Prosper Sets Interest Rates
Prosper uses an auction style format to determine the interest on each of its loans. On EBay, prices start low and are bid up. On Prosper, the interest rate starts high and is bid down. When borrower's create their loan listing, they must include the highest interest rate they are willing to pay. Much like EBay suggests starting with a low price to attract bidders, Prosper recommends starting with a high interest rate to attract lenders. Prosper describes this approach in its "Create a Loan Listing" help section. Prosper also will recommend a starting interest rate if you are unsure where to begin.
Lenders who bid on the loan must enter the lowest interest rate they are willing to accept. This interest rate is not disclosed to the borrower or other lenders. As more lenders bid on the loan, the interest rate comes down. Bids are ordered from lowest interest rate to highest, and by time of bid in the case of a tie. The loan is funded beginning with the lowest bids, and the final interest rate is determined by the last bid used to fund the loan. Prosper offers a nice example of this process in its Bid History help section.
What all of this means is that Prosper does not set the interest rate, the borrower and lenders do. Lending Club is a whole different story.
How Lending Club Sets Interest Rates
Lending Club sets the interest rate for the borrow and lenders based on a credit grade. The credit grades range from A to G, and each letter grade has a sub-grade ranging from 1 to 5. For each grade and sub-grade, Lending Club sets what it calls a base rate, which currently ranges from a low of 7.05% for grade A to 7.55% for all other grades. Lending Club then adds to the base rate a rate equal to two times the average default rate for the given credit grade. For example, the average default rate for A1 borrowers is 0.16%. Lending Club doubles that rate, adds it to the base rate of 7.05%, to arrive at the final interest rate for A1 borrowers of 7.37%. In contrast, the average default rate for a D5 borrower is 3.16%, which when doubled and added to the base rate of 7.55%, nets a final interest rate of 13.87%. To determine a borrower's credit grade, Lending Club uses the following 3-step formula:
Step 1: Each borrower is given an initial credit grade and sub-grade based on their credit score. As an example, here are the credit scores that will result in an initial credit grade of either A or B:
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Step 2: LendingClub adjusts the credit sub-grade based on the borrower's debt-to-income (DTI) ratio. A DTI ranging from 0 to 12.99% results in no adjustment. A DTI of 29% results in a downward adjust of 16 sub-grades. For example, an A1 borrower based on credit score would by lowered to a D2 credit grade if they had a 29% DTI. Here's the Lending Club table that shows how a borrower's DTI will affect their credit grade:
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Step 3: Finally, LendingClub makes another adjustment to the credit grade based on the amount of the requested loan. The loan amount is divided by what Lending Club calls a loan guidance limit, which is different for each credit grade. For example, the loan guidance limit for C borrowers is $10,000. If the requested loan is $7,500, the loan guidance ratio would be 75% (7,500 / 10,000), which would result in a further decrease in the sub-grade by 3.
How to Determine Which is Best for You
Borrowers want the lowest interest rate they can get. Lenders want the highest interest rate they can get, given the risk they are assuming. Because Lending Club sets interest rates using a published formula, it�s easy to determine in advance the interest rate for a given loan. Once the Lending Club interest rate is known, it�s a simple process to compare it to the interest rate Prosper auctions are generating for loans of a similar risk profile. Let's use this approach to compare two of my Prosper loans with the interest rate I would have received if I had bid on a similar loan at Lending Club.
I have five loans on Prosper, all chosen using Prosper's Portfolio Plans. Some of the loans can't be compared to Lending Club either because the DTI is above 29% or because the credit score is below 640, two requirements all Lending Club borrowers must meet. But I can compare two of the loans.
Loan No. 1
Credit Grade: C. A credit grade of C on Prosper means the borrower has a credit score somewhere between 640 and 679. It's unfortunate that Prosper doesn't give lenders a better idea of a borrower's credit score. From a credit risk perspective, there is a HUGE difference between a credit score of 640 and 679.
DTI: 11%
Loan amount: $4,500
Final interest rate: 11.50%
Using the formula on LendingClub, we can determine that this borrower's starting credit grade would have been somewhere between a D5 and a B5. Why such a big range? Because Prosper doesn't give us a more precise indication of the borrower's credit score. A DTI of 11% would not have resulted in any adjustment to the credit grade. The loan amount of $4,500 would have resulted in a reduction of the sub-grade by 1 or 2 sub-grades, depending on the borrower's initial credit grade. From this information, we know that the interest rate this borrower would have paid at LC is somewhere between 11.03% (sub-grade C1) and 14.18% (sub-grade E1). So the interest rate I'm earning at Prosper is within the range I would have earned at Lending Club, although there is a real possibility I would have earned more at Lending Club, depending on the borrower's actual credit score.
Loan No. 2
Credit Grade: AA (credit score of 760 and up)
DTI: 25%
Loan Amount: $9,500
Interest Rate: 8%
Running these numbers through the LendingClub formula yields an interest rate of between 12.29% (sub-grade C5) and 12.61% (sub-grade D1). Again, we have a range because of the somewhat less precise information Prosper offers about a borrower's credit score. Regardless, the difference in the interest rate is dramatic. Why?
I believe the reason is two-fold. First, there are a lot of lenders bidding on Prosper loans at the moment, which brings down the interest rate. Second, Prosper lenders are underestimating the importance of DTI. This borrower's DTI of 25% is significant, particularly given that DTI does not include rent or mortgage payments. His AA credit grade certainly reflects a good credit history, but a DTI of 25% raises a significant risk that his cash flow will be insufficient to service the loan.
Final Thoughts
Whether you are a borrower or lender, the starting place should be to determine the interest rate you would pay or receive at Lending Club. As a borrower, there would be no reason to pay more than this rate on a Prosper loan. And as a lender, there would be no reason to accept less. The fees Prosper and Lending Club charge should also be considered. Lending Club's fees for borrowers (.75% to 2%) are slightly lower than Prosper's (1% to 3%). In contrast, Prosper's fees to lenders are lower than Lending Club's for loans made to AA borrowers (0% at Prosper compared to 1% at LC). Lender fees for all other loans are the same for both at 1%.
For borrowers with a DTI below 11%, I think interest rates between the two sites will be very competitive. As the DTI moves higher, however, I suspect the rates will be better for borrowers at Prosper, and better for lenders at Lending Club. Because Prosper rates are set based on lender bids, there is always the very real possibility that interest rates at Prosper will not reflect the default risk presented by the borrower. Furthermore, Prosper bids will be influenced by factors not relevant to credit risk, such as how the borrower presents himself or herself in the loan listing, whether they include their dog or child in the photo, whether they are attractive, and so on. These irrelevant factors will lead to opportunities for both borrowers and lenders that will sometimes favor Prosper and at other times favor Lending Club. At present, I suspect that many Prosper lenders are underestimating the risk of default, which results in better interest rates for borrowers at Prosper, and better interest rates for lenders at Lending Club.
If you'd like to sign-up to be a lender or borrower, you can use the following links:
- Lending Club.
- Prosper--Update: As noted above, Prosper has suspended its lender program for now. We will update this post when Prosper's lender program resumes.
Image Credit: Wolfgang Staudt
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Damn, that is a great post. Thanks for the info, that must have taken a bit of research!
I’m with David. This is an excellent overview. They have such similarities…but the differences are significant for lenders. I think this is probably the best explanation I’ve seen of the bidding process on Prosper. I’d prefer the Lending Club, I think… I’m still not sure I’ll lend on either, but it’s good to know.
Thanks.
David & Mrs. Micah, the difference in how interest rates are set was a recent revelation for me. In fact, I emailed Lending Club to make sure I understand their process. I had initially just assumed LC used a bidding process, too. But as I dug into the details, it became clear that the process was very different from Prosper’s. I’m glad you liked the article.
Great job giving people considering either choice the information we need to make a decision.
Very nice article. I thought the process was similar until I did a little more digging. I likened Prosper to eBay, and Lending Club to Amazon. I thought it was a fair assessment given the lending styles. And if I were a borrower, I would definitely choose Prosper. The chance of having my interest rates bid down is good enough that I would go that route.
Can you back up the claim that there is a HUGE difference in risk between credit scores of 640 and 679? Actually, I’d suggest that other factors are much more important, and simply cutting the credit scores into smaller chunks is statistically irrelevant. You’re going to get a much larger change in risk based on home-ownership or the percentage of credit card credit used — so much so that a 10 point difference in credit score isn’t even worth worrying over.
Of course, I don’t have more data, and lending club doesn’t have any default data I could find (and hasn’t been around long enough to have statistically significant data either way). I’d suggest that you be really careful of treating credit scores as some sort of panacea though. At Prosper, most lenders (through the portfolios) take into account a range of data from credit score, to DTI ratio to credit utilization to the amount of the loan. You should take a look at lendingstats.com to get a feel for all the data available before deciding that Prosper offers worse rates for lenders.
From a credit risk perspective, there is a HUGE difference between a credit score of 640 and 679.
Deamiter, I absolutely agree that other factors besides credit score are critical to assessing credit risk. In fact, that is where Prosper lenders make big mistakes; they rely too heavily just on credit score. Lending Club’s formula takes into consideration debt-to-income ratio and amount of the loan. Credit utilization is another important factor as you mention. But credit score is still very important, and the historical default rate for a credit score of 640 is 3.16% compared to a default rate of 1.58% for a credit score of 679. This data comes from Lending Club, which gets the data from TransUnion. And a difference of more than 1.5% is HUGE in my opinion.
Very interesting article.
I think one of the things that helps borrowers on Prosper is the sheer number of lenders who just want to lend money on Prosper and aren’t doing anything close to the analysis that you did.
Kind of like a hot stock – some people just want to own it.
Mike
Four Pillars, you are absolutely right, which may lead some to regret their investing decisions.
I’m still not sure why you keep claiming that Prosper lenders don’t take all these factors into account. As you’ve lent at Prosper, you know that they give you the default information when you place a bid. I suppose there are probably people who ignore the estimated return (including fees and the default rate) and just look at the loan’s interest rate, but since the default information (calculated using the wide varity of factors we’ve been discussing) is right there at every single bid, I’m not sure how you’ve concluded that Prosper lenders focus solely on credit score.
From my perspective, there are likely small pockets where one of the sites might outperform the other by up to 1% or so, but on the whole, they both use the same information to calculate the same default rates — the only difference is in bidding vs. “buy it now” pricing.
I’m not particularly invested in Prosper being better (except that I have money in Prosper and would prefer not to think I made a mistake) but I still don’t see any justification for your repeated claim that Prosper lenders focus more on credit score than LendingClub lenders. In fact, I’d think it’d be the other way around — in breaking down credit scores into such tiny packets, it encourages lenders to focus on points rather than treating credit score as just another general category.
In the end though, I think it’s a mistake to treat lenders as if they’re carefully making decisions since a majority of loans on Prosper are funded at least in part through the portfolio plans which drive the rates to preset values — much like LendingClub.
Deamiter, I too have Prosper loans. My point here is not that lending on Prosper is a mistake. But I do suspect that lenders in general are not very good at assessing credit risk, and most probably haven’t even considered interest rate risk. What’s interesting to me are Prosper’s portfolio plans, which I’ve used. These plans put me into an 8% loan with a borrower who as a DTI of 25%. LC would have charged this same borrower more than 12%. That’s a significant difference, and obviously in that one case Prosper was better for the borrower and LC would have been better for the lender. Of course, that was just one loan. Although there is quite a bit out on the web now suggesting that the number of lenders on Prosper is resulting in low interest rates that do not fully account for credit risk. My question back to you would be why do you have so much confidence in Prosper lender’s to properly assess credit risk? I read financial statements all day for a living, and I don’t think for one minute that I’m qualified to assess a borrower’s credit risk. That’s why I used Prosper’s portfolio plans and why I believe everybody should assess a Prosper loan in light of what interest rate that same loan would generate on Lending Club.
I don’t think I’m qualified (in any way) to assess credit risk, but Prosper does that for you by giving an estimated default rate for any given loan. My understanding is that LendingClub determines default rate solely on the basis of the credit score, and then just bumps up the interest rate based on other factors like DTI. Instead Prosper uses all these factors to calculate the default rate in the first place and allows lenders to make decisions based on a much more complete assessment of default risk.
Again, I’d suggest you spend some time on LendingStats.com as depending on the other details of the loan, 8% could be quite reasonable. For under $10,000 loans, with a DTI around 25%, there are no historical defaults and only 1% late (by no more than a month though). Since the default rate is so low, the average rate is quite justifiably 8.66%.
I should be very clear that I highly value this post of yours! Also, I too am quite wary of the portfolio plans — they funnel too much money into specific loans driving the interest rates below market value in my opinion. Lendingstats.com gives a very good idea of how different factors have historically affected default rates. You have to understand statistics pretty well to accurately interpret the data (for example, it’s important to understand that default rates will be somewhat underreported for loans originating less than 3 years ago) but even a novice can get decent relative default information.
But I digress, I just want to be VERY clear that I personally value this post quite a bit. Coming from a scientific background, I sometimes forget that nitpicking isn’t the norm for everybody. I apologize if I came across as arrogant or argumentative — I’m afraid I’m accustomed to a culture where we tend to express value for others’ ideas by quibbling over details and in my excitement over such an interesting topic, I forgot to rein myself in.
Deamiter, it’s the comments that take a different perspective than mine that are the most interesting to read. I always welcome a different point of view.
You are completely right about Prosper lenders underestimating the probability of default. The people making these loans generally are not trained to assess risk, such as an actuary. I did a detailed post on my blog about the risks of P2P lending and the lenders are NOT being compensated for their risk as they should be based on simple mathematical analysis. Lending Tree is better, but I think that the DTI ratio is too restrictive. There are a number of reasons that DTI may be higher that won’t have the equivalent of a 16 subgrade drop in creditworthiness; most banks use a 36% DTI ratio as their cut off. Look at these loans with a skeptical eye, if other financing is available why would someone use P2P? To get a lower rate than their credit would otherwise support! Lenders beware.
Adfecto, the 36% DTI you reference, does it include mortgage/rent payments? Both Prosper and Lending Club exclude mortgage/rent payments in their DTI calculations.
FYI, Prosper uses Experian Plus Score, which differs from FICO credit score LC uses. This means that the score bands are not directly comparable.
Also to Deamiter, your argument is entirely based on the reliability of Prosper’s estimated default rate, which is a good reference, but I’m not sure if it is statistically significant yet. First of all, the history is too short. Secondly, you are talking about a total of 18 loans for $77K (from Prosper’s performance data). That’s not enough to get a statistically significant number. Therefore, whatever Prosper uses to estimate the default rate would likely not have enough data points to be reliable either.
Don, thanks for the info. I would add that Prosper and LC default rates are not comparable for other reasons, too. Most importantly, LC doesn’t use default data from LC loans to set its interest rates. It uses default data from TransUnion, which I believe would be far more useful than the limited default data available on either Prosper or LC loans.
Thanks for the great research. That clears up some mysteries of the LC method. that I had.
Odnal, I’m curious if after reading the article, which method for determining the interest rate do you prefer?
Wow! I’ve been studying money and investing for a while, but I didn’t know P2P borrowing was getting so deep! I learned a lot, keep the good articles flowin’, sir..
I’m thinking of investing in P2P lending and have been reading blogs, websites, etc. to prepare. This is the best side-by-side comparison of Prosper and LC that I’ve seen.
I’m leaning toward LC, as it’s overall a simpler approach for busy me. I don’t have time to calculate over and over again which loans at what amounts would fit neatly into my investment strategy while the kids are killing each other, dinner is burning, etc. By giving me a chart, I can select a range of credit ratings, say B-D, that give me the best yield at the most acceptable risk (for me) and then invest accordingly.
And I hate the idea of bidding on loans. It just reeks of testosterone (sorry, guys) and doesn’t fit my no-surprises personality.
Thanks for this info. It helps immensely!
While P2P lending is a fascinating topic, how stable/reliable both companies are? After all they aren’t providing any FDIC insurance and are asking for SS and bank account numbers.
What happens if their financial models are not working out or they having liquidity problems? They have been in existence for such short periods of time.
Will appreciate people’s thoughts. Tnx.
Mike, the key to remembers is that Lending Club and Prosper service the loan. If either company goes under, they would simply transfer the servicing of the loans to another company. Here is Prosper’s explanation of what would happen should they go out of business: “In short, no new loans would be created, all lender funds not actively associated with a loan would be returned to the individual lenders immediately, and all existing loans will be serviced to completion by a third party loan servicing agent.
If Prosper were to go out of business, the third party loan servicing agent would take over the administrative responsibilities such as the transfer of monthly loan payments, providing timely payment notices, monthly lender statements and required tax documentation, overseeing the collection of delinquent loans on behalf of the lender, and reporting payment performance to credit bureaus.
Borrowers of course are still obligated to make payments on their loan. Prosper’s existence (or lack thereof) does not change that obligation legally or otherwise, and failure to meet those obligations would result in the same consequences for the borrower.”
Of course, loans on Prosper and Lending Club are not FDIC insured, just like corporate bonds are not FDIC insured. So the risk of default is a very real risk that must be considered before investing in P2P loans.
You might want to update this article. Lending Club is the better choice for one reason; it is SEC approved, whereas Prosper received a “cease and desist” letter from the SEC.
Currently, the only legal game in town is Lending Club (http://www.lendingclub.com)
DR, Very nice post and comments. I would agree that Lending club, especially with new rules is probably a better deal for lenders than Prosper if it comes back with the same system. Liquidity concerns could be answered a little by the new note selling feature on Lending Club. However, one thing I would like to point out about P2P lending in general is that for the lenders the interest rates on these loans are not directly comparable with interest rates and returns on CDs or savings accounts ignoring default risk and liquidity. In general interest rates on a P2P loan have to be about twice the interest rate on a CD or savings account for the same duration to result in similar total cumulative return. You can see the detailed calculations and explanations here.
bill, not so fast; Prosper is simply going through the same registration process with the SEC that Lending Club did a few months ago.
zylstra, that’s right. Prosper originally filed an S-1 registration statement with the SEC first, but messed it up. Now they are behind Lending Club. The big difference is that LC has a secondary market for its notes where investors can buy and sell existing loans. Prosper won’t be able to do this until its S-1 goes effective.
There’s really no buyer for your notes, unless you sell for a loss. Recently, the number of people lending money have dropped off drastically. As for you paypal deposit, you have to use it all with LendingClub or they’ll lock your account out. Imagine that, having your account locked out when it’s not even in the contract.
A company that makes up new unadvertised rules with your money. You decide.