When I tell people about Prosper loans, for some reason they always make the wrong assumption about the way interest on the loan is calculated. They seem to always think that somehow the total return is always a simple calculation of the principal x interest rate x 3 years.
Interest is not compounded yearly in a Prosper loan; the easiest way to understand a payment schedule in Prosper is that it resembles a mortgage. Now this is not an exact comparison, but should serve to dispel a common myth for both lenders and borrowers.
Let’s look at the numbers on a pretty simple loan:
$1,000 at 10% for 3 years.
With the assumption many make the return would be $100 annually with a total of $300 interest earned over the course of 3 years.
One friend even suggested it compounds, so that at the end of the first year, the person is actually paying interest on $1100, and will owe $110 the following year, will be paying interest on $1210 the third year and will owe $1331. This means that at the end of the loan period, a profit of $331 was made on the $1000 investment. This would be great for lenders wouldn’t it?
The reality is that the payment schedule calculates a monthly payment by taking the interest rate calculated on a daily basis so that you make a consistent payment. This way the interest is quite high early on and steadily goes down until the last payment. Towards the end of the loan you are paying much more principal than interest, just like a mortgage.
You can use the mortgage calculator and see what the schedule would look like yourself.
So let’s look at some real numbers. How much interest would you earn/pay on a Prosper loan for $1,000 at 10% for 3 years?
This would calculate out to about a $32.30 monthly payment for 36 months. At the end of the loan, you’d pay/earn a total of about $160 in interest, or about $53 a year. Now these are flat averages across the term of the loan, not the actual yearly return.
As a lender, in reality, it may not look like you are getting a lot of return on your money. But, keep in mind that your original capital is being returned to you monthly so that you can reinvest it. At the end of the first year you’d get back about $300 of your capital. If you reinvested it as it came in, you would actually start to approach the cash return quoted at the top of the article, but don’t compound calculate every loan you make or your earnings will be wildly overstated.
You can get a $25 bonus to join Prosper as a lender here.
Labels: Calculating Return