Figuring Prosper's Maximum Allowable Loan Rate

I often get confused when I look at a state like New Jersey that has a 16% interest rate cap due to state laws but then see listings where the maximum interest rate is 12.84%. This makes no sense in any practical universe, so what's going on? The answer, my friends, is a confluence of Prosper's payment choices and government regulation (see, it doesn't have to make sense).

The Bank Draft

Prosper allows lenders to choose between 2 loan payment methods: bank draft and electronic funds transfer (ETF). The ETF method is quick and painless, and free. Prosper charges 1% for the bank draft method, however. And, because a borrower can swap between the two methods on a whim at any time during the loan, Prosper must make sure that, should a borrower choose to use the bank draft method during a loan, their effective interest rate will never exceed the state maximum. So, take 1% off the state rate limit.

Government Regulation and APR

Some state government require interest rate limits to be based on the effective Annual Percentage Rate (APR) instead of the simple interest rate. This came about because lenders were adding huge fees while keeping the interest rate low (sure, we'll make you a loan at 6%, after 10% in origination fees and closing costs). Lenders are required to account for those origination fees in their APR calculation, and it breaks down like this. I have "C" credit and want to get a $10,000 loan in New Jersey for 12.84%. Because "C" credit grades have a 3% closing fee, Prosper won't pay me $10,000, they only pay me $9,700, with the other $300 staying with them as a closing fee, and a monthly payment of $336.17. The state of New Jersey sees it differently. They see a monthly payment of $336.17 on a loan of $9,700. It would take an interest rate of about 14.98% to get that. 14.98% is considered the the APR rate.

So now, lets put it all together. You'll notice that there's a little bit of slop in the math, but at 0.02%, it is a rounding error. If you're worried about the 0.02%, you've got bigger things to worry about.

16.00%	State Legal APY Limit
-1.00%	Bank Draft Margin
-2.14%	Closing Costs Adjustment
-0.02%	Slop In The Math
12.84%	Maximum Allowable Rate

Of course, this calculation will vary from state to state. Some set interest rate limits, others set APR limits, and I'm sure a few have even goofier methods of limiting loan shark lender rates.