Tuesday, March 18, 2008

What Should My Target Prosper ROI Be?

With the Fed dropping interest rates like they're going out of style, it's an appropriate time to discuss what average annual return to expect from Prosper. The easiest way to look at it is to say "I'd like to get 10%". Unfortunately for us individuals, this is not how the finance world operates, and, in an bidding system like Prosper, this matters.

We're competing for borrowers who have alternatives like traditional banks. These banks set the rates borrowers pay based on the prime rate plus some fixed offset to compensate for an individual's credit risk. This effective indexes the bank's return to the prime rate, which is, in turn, indexed to the Fed Funds rate (that quickly dropping number). In this same vein, lender should index their expected return instead of always anticipating a certain return amount.

Ok, so what should lenders use as an index? I have often looked toward a number that corresponds to the risk-free rate of return I can get on my money. As in, how much can I get for no effort and virtually no risk? My index of choice for Prosper loans is my bank's 3-year CD, though this can be approximated by Bankrate's 3-year CD list. I then add a percentage, typically 5%, on top to provide additional cushion for the risk. This is my target average annual return on Prosper.

My long-time target was 10%, back when the economy was fine and CDs were 5%. And, despite some rather bonehead newbie bids, this was still achievable. Since that time, I've revised my target down to 8% as interest rates have fallen. I suspect that I'll be revising downward again real soon.

To use this number, I make sure that my estimated return for every bid exceeds my target average annual return. Happy bidding.

3 comments:

j9359 said...

An interesting post.
But I do question whether Prosper rates should fall just because short term (and risk free) rates are going down. For one thing part of the reason we are in such a mess today is that the risk premium had shrunk in the last few years so that lenders were taking on much more risk for very small increases in return. So Prosper rates don't have to fall and neither does lender ROI. Actually if you calculated your ROI as excess return over the risk free rate your ROI would be going up!

Mike said...

Ok, I've reread this a few times and I still don't understand your argument. Could you try again?

Anonymous said...

any updates coming ?